Option Spreads With Large Upside and Limited Downside

In this article I will talk about some option plays I have been / will be using to capture a potential large upside with a limited downside. I’ve been very bullish on commodities lately which will explain some of the equities I've used early in this article.

In this article I'll be talking about Bull Call Option Spreads, to understand this you must be familiar with stock options. To learn more about stock options visit my BLOG.

All of the strategies used in this article are currently priced with the higher end of the option spread having a greater than or equal to 40% chance of expiring in the money, and having the potential of returning at least double your initial investment if they hit and close above the higher strike price of the spread (according to options pricing as of pre-market Wednesday May 27).

Spread Strategy # 1: Buy the SPDR GOLD Trust (GLD) July $94 Call and sell the July $96 Call. The $96 call option is factoring in a 42.9% chance it will expire at or above it at July expiration. If it happens to expire at or above $96 return would be 150%. Similar strategies can be used for GOLD,UGL,GG,GSG, and other gold and mining equities.

Spread Strategy # 2: Buy the United States Oil Fund (USO) June $34 Call and sell the June $35 Call. The $35 call option is factoring in a 41.4% chance it will expire at or above it at June expiration and would return 122% if it did. Similar strategies can be used for UCO, XLE, UNG, DIG, XOM, and other oil and gas equities.

Spread Strategy # 3: Buy Apple (AAPL) July $130 Call and sell the July $135 Call. The $135 call option is factoring in a 44.9% chance it will expire at or above it at July expiration. If it happens to expire at or above $135 return would be 108%. Similar strategies can be used within the tech sector on stocks such as RIMM, PALM, AMZN, EBAY, GOOG, YHOO, MSFT, and many more.

Spread Strategy # 4: Buy SPDR S&P Depository Receipt (SPY) July $92 Call and sell the July $93 Call. The $93 call option is factoring in a 43.4% chance it will expire at or above it at July expiration, and would return 108% if it did. Similar strategies can be used for the DIA and the QQQQ. If you want to take on more risk with a greater potential reward you could also use a similar strategy with the leveraged ETFs such as SSO, BGU and many more.

Spread Strategy # 5: Buy the Financial Select Sector SPDR Fund (XLF) September $12 Call and sell the September $13 Call. The $13 call option is factoring in a 43.8% chance it will expire at or above it at July expiration. If it happens to expire at or above $13 return would be 122%. Similar strategies can be used for other sector ETFs such as XLP, XLU, XLY, XLV, and XLK, as well as individual financials such as AXP, BAC, BK, C, GS, JPM, and many more. If you want to take on more risk with a greater potential reward you could also use a similar strategy with the sector leveraged ETFs such as UYG, FAS, UYM, and many more.

All option spreads must close at or above higher end of the spread at expiration to receive the maximum profit from the strategy. It is possible to lose 100% of your investment if the underlying equity closes below the lower end of the spread. These spreads can be traded which I find works well in this volatile market.

With many stocks it is possible to find a strategy that offers a 40% chance of expiring at or above that returns 100% profits. The odds are still not in your favor, but it is a way to capture a large upside with minimal downside. By choosing different strike prices and expiration dates you can adjust the chances of expiring in the money, and the profitability from the spread. I use the 40% 100% rule as I never have to go out too much further than 3 months- keep in mind a lot can change with options pricing overnight.

Disclosure: Long UCO,PALM,GOOG,SSO,UYG,...

Comments

[User 305589:]

hm, let me get this straight: you talk of 'large upside and limited downside' - yet when looking at your vertical call spreads that you suggest, you have an upside of 108-150% and a downside of - 100%(!!)
I am myself doing a variety of vertical call spreads as well as calendar spreads, but frankly, your suggested trades look more like a gamble.
Your strike prices are so precariously close to each other and at the same time mostly out of the money and pretty near to expiration. For instance, the SPY calls with 92 strike have only a slightly higher probability of expiring in the money than have the 93s. It's basically a coin toss, imho.

I do like call spreads, though, but I use them either with long term options for stocks that are grossly undervalued imo, and then I go quite deep out of the money for 3.1 or 4:1 upside/downside.
Or I may target stocks which I consider to be a t rock bottom valuations with very little downside left and then chose calls that are in the money while selling calls at or slightly out of the money.

May 27 07:42 AM

[Rayn:]

So basically the limit of this downside is that you can only lose your entire investment.

May 27 08:25 AM

[TCK:]

Must be trading for free as the commissions on two trades in and out will dramatically effect the percent returns.

Also makes the risk/reward ratio much different as you will add commissions to your original investment and possible loss.

May 27 09:31 AM

[ERCaptain:]

Now, please don't get offended, but from where I am from, when the potential risk equals a total loss of the "net" investment, it is not actually investing. It is gambling. You are betting against the board that you are going to be right on these recommended transactions.
Options are a great way to transfer risk, increase total returns (in ways that are safe enough for widows and orphans to do), and take on measured risks to get attractive entry and exit points to the market. I also think there can be a place for very aggressive strategies for a small piece of an investors investments, but these strategies are not really for serious investors with serious money.
I like that there is no unlimited loss potential in this advice, but it would be nice to have some way to preserve some of the "risk capital".

May 27 01:47 PM

[AussieTim:]

I've got a trade with better risk/reward:
50% chance of 100% return and maximum loss also capped at 100%. Its called a coin toss.
Sorry I don't know how else to put it: This guy has no idea.

May 27 04:51 PM

[Philip Cohen:]

Hey, the intention is not that investors make any money but simply that they keep trading in the hope ...; that way the brokers eventually finish up with it all.

May 27 06:01 PM

[Angela M:]

The way I look at it is investing today is a gamble period. This is a high risk high reward strategy. For the SPY strategy, a move of 4% or more in the coming 52 days would return more than double your money. Marco never says to invest all or even any of your money in these strategies, and lays out the potential risk. The market for options is growing at a tremendous rate and why do you think that is? Opening up a call contract position is riskier than opening up a spread position. Get with it!


On May 27 04:51 PM AussieTim wrote:

> I've got a trade with better risk/reward:
> 50% chance of 100% return and maximum loss also capped at 100%. Its
> called a coin toss.
> Sorry I don't know how else to put it: This guy has no idea.

May 27 07:20 PM

[BizBroker:]

I wouldn't bet against Ford for any reason. It's unAmerican.

May 27 11:18 PM

[daniel3582:]

This article isn't very useful, in terms of information. I have three Web sites in my bookmark bar that could have given me the probability of any of these spreads expiring in the money. So...

Why these strikes? Why these symbols? Why calls and not puts? Why these expiration months? Tell me something I don't know!

May 28 10:17 AM

[Henrietta:]

Large upside and limited downside huh? I thought you were talking about the inverse ratio between eBay CEO John Donohoe's ongoing attempt to find his rear end with both hands and a flashlight and the continuing exodus of eBay's customers, the sellers who pay the marketplace fees.

Your strategy sounds like a very small car spinning its wheels and making lotsa dust.

Jun 02 11:12 PM