The rally that sent the major market benchmarks up 10% in the eight days surrounding the beginning of the war has been tempered in the last week, but its implications are still resounding. That push to the upside provided a glimpse of the pent-up buying power out there -- which includes both short-covering and fresh purchases -- and how the market could react to positive news.
The dilemma is that it's tough to commit and risk capital in the current environment, but you also don't want to miss a big surge that could leave you weeping on the sidelines.
Choose Your Weapon
Last week I
wrote about using options to start building bullish positions and dampen the effect of price swings. There are a variety of methods you can try, and as always the option strategy you use should be appropriate to your trading style, market conditions and expectations. For instance, if you're a long-term investor, don't buy short-term calls with less than 30 days remaining in the life of the contract.
I'm going to look at three distinct bullish strategies -- call spreads, calendar spreads and an approach that is probably best left to those traders with a lot of experience. All three offer ways to start nibbling at long positions, but each has a very different risk/reward profile. The application should be aligned with given circumstances and agree with the expected scenarios.
How big a price move you expect and over what period of time are the two big variables that will help you determine which strategy to use. And always keep in mind the risk or potential loss.
The Basic Call Spread
The basic vertical call spread is one of the most straightforward and popular option strategies. It offers a very clear and limited risk/reward profile and needs little monitoring or adjusting once established. The strategy involves the buying of a call and selling a higher strike call with the same expiration on a one-to-one basis.
The call spread should be used when you expect a moderate rise in price over an intermediate time period. Good candidates for call spreads are low-beta stocks (ones whose price changes at a slower rate relative to the overall market) that appear to have solid fundamentals.
Currently, defense stocks might be ripe for vertical call spreads. Shares of
all fell precipitously over the past year. But each has bounced over the last two weeks as the continuing war in Iraq has generated talk of increased revenue for replacement parts and an enlarged military budget.
Taking Lockheed as an example, with the stock trading at $48, you could buy the September $50 call for $3.70 and sell the September $60 call for $1.20, for a net cost of $2.50. The maximum profit is $7.50 per spread. The advantage of spreading vs. an outright purchase of the stock includes the fact that the loss is limited to the cost of the spread, and you don't need to be as concerned with identifying exact entry and exit points.
A calendar spread is also a good choice when you anticipate a slow, steady rise in price. This method involves buying a long-dated call and selling a short-dated call on a one-to-one basis. But unlike a vertical spread, which will benefit from a quick move up in the near term, the calendar spread needs the stock price to rise slowly or stand still early in the position in order for it to be effective. The upside of the calendar spread is that it provides for unlimited profit potential.
Calendar spreads require a bit more of an ability to game price action over time to achieve the benefits of a reduced-cost long-dated call. Candidates for this strategy would be stocks that are likely to remain under pressure in the near term but have the potential to collect big gains on future positive news flow.
The retail sector seems to offer a compelling case for calendar spreads. The spring season is looking weak and consumer confidence is at its lowest level in a decade. But the retail companies should be some of the biggest beneficiaries if the economy turns.
as a proxy for the sector, with the ETF trading at $70.25 on Tuesday, you could sell the May $75 call for $1.20 and buy the October $75 call for $3.80, for a net cost of $2.60. While the maximum loss is limited to the cost ($2.60), in order to achieve the most benefit the calendar spread requires a bit more monitoring than the vertical call spread.
An investor needs to make a decision regarding if and when to roll the front short call into the next month. It's a balancing act between further reducing the cost of the long October call and limiting future profit potential.
For Pros Only
Finally I'll address the idea of selling puts naked short. I must emphasize that this strategy offers limited profit potential and exposes you to unlimited losses. This approach should only be used by experienced traders who monitor the market and are willing to assume large risk.
That said, in the current high volatility environment, put selling offers a great way to generate premium income. It also sets up a means for buying (getting long) stock at prices below the current market.
Though the idea of collecting premium can be enticing, your willingness to be assigned stock if the shares fall below the strike price should determine whether the strategy makes sense.
Naked put selling should be underpinned by a strong fundamental and technical opinion -- almost to the point where you feel that a stock is such a good buy at the break-even point that you actually hope the price of the underlying drops and allows you to get long. An increase in the stock price and the accompanying collection of premium should almost be viewed as a consolation prize. So, unlike the prior two strategies, naked put selling should focus on shorter-dated options.
An example might be
. With the shares at $79, you could sell the May $75 put for $3. This gives you a break-even of $72, meaning if IBM falls below the $75 strike you'll be long shares at a cost basis of $72. You wouldn't want to employ this strategy unless you think IBM is a great buy at $72.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to