My dad retired as a pharmaceutical salesman—one of the best in the company in fact (if not the best, but I am partial). Selling has always been in my blood.
When I was younger, I sold fresh fish from the river. I would catch them and sell them to those at The Landing. The place I lived near was Williams Landing in Statesboro, GA. Feel free to Google Map it; quite a remote place. The Landing is where the boats would enter into the river. At the time, I could catch a fish in a watermelon patch. Selling fish to those camping at The Landing was a fun little business venture when I was six-seven years old. I say this to again say, selling is in my blood.
SELLING OPTIONS
That’s why I love selling options. There are literally countless option strategies. I will cover the most basic form of option selling strategies, in combination with option purchasing. It’s known as the debit spread.
DEBIT SPREAD ON SBUX
Let’s focus on a specific stock to make the example easy. Starbucks Corporation (SBUX) is in a Bollinger band squeeze, of sorts, at an all time high. SBUX had a nice bullish gap in September. As an example, say an investor was longer term bullish on SBUX. The investor could purchase an $80 April, 2014 call option for approximately $4.30 per contract. Therefore, controlling 1,000 shares would only cost $4,300. That would be 10 contracts. Then the November $82.50 call could be sold to open, brining in 1,000 (shares) x .62 cents (the value of the November option).
This limits the traders profit in this scenario. As I write this SBUX is $77.69 per share. Therefore, the MAX reward on this trade is currently $4.81 cents a share (plus) the premium brought in from the call sale. Therefore, $4.81 + .62 = $5.43. MAX loss is $4.30 (cost of the option) – .62 = $3.68.
HOW IT WORKS
Here is the cool news! If SBUX closes below $82.50 on the 3rd Friday of November, the investor keeps the $80 call options and the .62 cents premium from the option sale and could do this exact same transaction for December, 2013. Best case scenario, SBUX closes at approximately $82.30 or so on November 15 (as long as it’s below $82.50) and a higher strike could be sold, perhaps the $85 strike, increasing the max reward and decreasing the max loss at the same time. If you could sell an option bringing in .62 cents each time, between now and April, 2014, you could have 4 options sales between now and February. That would be $2.48 of option premium, when your original option only cost you $4.30. You now have 2 months (beginning February, 2014) to see if SBUX would go any higher, literally having 10 contracts that only cost you $1.48 per contract.
If the stock does begin to go higher than the call option you sold, you simply have to buy to close that call. You truly do not want the stock to expire above the call option you sold. YOU DO, as a trader, want to ensure you either A) buy to close the sold call if the stock will expire above the strike you sold or B) close both positions, selling your original call and buying to close the sold call, realizing your capped profit. However, feel free to contact your broker to determine how your broker would handle this situation. Make sure you understand option expirations before doing this strategy.
GETTING STARTED
This strategy has many names. It could also be called a Calendar Spread, or Leap Spread, or Covered Option Spread but it’s still a Debit spread, because you are spending a large amount of money upfront, selling options to pay for that initial purchase, while limiting your loss, limiting your reward, yet still using option leverage to your advantage.
If this strategy is brand new to you, I would suggest trading it and trying it virtual if you are unfamiliar with it. This strategy is somewhat similar to my favorite strategy (the covered call) but you do not receive dividends when owning call options and as a trader, you still have to deal with the option value absolutely decreasing with time. This strategy can work quite well, if you time it properly, sell the right strike prices with the right amount of time and unravel if needed.
Feel free to let me know if you have any questions!
