As investors, we all have slightly different goals and objectives. In very basic sense, we all want one thing: to make some money!! Yet, we might use options in different ways. For example, while one investor only trades bearish spreads to help offset potential volatility from holding a larger stock portfolio, another might have allocated 20% of their assets to more speculative trading - like out-of-the-money call purchases and call spreads. The first step is to identify your long-term goals and objectives - then decide what type of options trades will help you get there.
Once you have found trades that seem to match your goals, objectives, and risk tolerance, the next step is to analyze each individual idea. I've been looking to add a position in a metals name, because I currently have little exposure to gold or silver. My colleague Henry Schwartz today wrote up an interesting Hot Topic about a beaten down silver mining name - Standard Silver Resources (SSRI). Like him, I find it interesting that the recent options order flow in the stock has been bullish - even as shares probe 52-week lows. SSRI seems ripe for a potential upside play.
Shares rallied to $15.78 this morning and are now up $0.84 to $15.20. The trade idea was to buy the March 16 calls on the stock for $1.60 and sell March 20 calls at $0.60. That is, the trade idea is to buy a March 16 - 20 call spread for $1.
A plain vanilla call spread is easy to analyze. In this trade, the strategist is paying $1 for an upside call spread. The breakeven at expiration is equal to the lower strike plus the debit, or $17. The potential profit is the difference between the two strike prices minus the debit, or $3, and happens if shares rally to more than $20 through mid-March 2012. At that point, the spread equals $4 and the profit is $4 minus the debit. The entire debit is at risk if the position is held to the expiration and SSRI settles below $16. At that point, both contracts expire worthless and the premium paid is lost. I am risking $1 to make $3. I am also taking a short-term bullish position designed to give me upside exposure to a mining name.
While the risks and rewards of a call spread are relatively easy to analyze, sometimes it's helpful to create a risk graph or payoff chart. Many online brokers and some options-related web sites offer them free. For example, the chart below from optionsXpress shows the potential risks-rewards from the SSRI March 16 - 20 call spread for a $1 net debit. The blue line shows the potential payoff at expiration and confirms that I'm risking $1 to make $3. The breakeven is at $17, with the debit at risk if shares close below $16. I can also plot a second date (green line). In this case, the second line reflects the expected risk curve two months from now.
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