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Will the rally continue in August? Nobody knows for sure, but in this article are some option plays I have been/will be using to capture a potential large upside with a limited downside.

This is a good strategy to use during this time, as the market could sell off slightly after that huge run in July, but could continue to rally through August with all the money still gathering almost nothing on the sidelines.

At current share prices these ideas are currently profitable (assuming they expired at the current close price), and this strategy allows you to:

  • Get in these ETFs for less
  • Capture upside gains if the market continues to rally
  • Limit downside loss if the market sells off

In this article I'll be talking about Vertical Call Option Spreads, to understand this you must be familiar with stock options. To learn more about stock options visit my blog or check out my E-Books here.

All data as of market close July 31, 2009.

Option Spread Strategy #1: Buy the SPDR S&P 500 (ETF) (NYSE:SPY) August $95 Call and sell the August $100 Call. The $100 strike call option is factoring in a 41.7% chance it will expire at or above it at August expiration. If it happens to expire at or above $100, the return from this position would be 65% in 20 days. The maximum that can be lost if the SPY happens to close at or below $95 per share at August expiration is $303 per contract.

The ETF is currently trading above the break even price of $98.03 per share, so as of now the position is profitable. This is a great strategy to look at if the market continues to rally, while it limits the risk to $3.03 per share.

Option Spread Strategy #2: Buy the Diamonds Trust, Series 1 (ETF) (NYSE:DIA) August $88 Call and sell the August $93 Call. The $93 strike call option is factoring in a 37.6% chance it will expire at or above it at August expiration. If it happens to expire at or above $93, the return from this position would be 65.6% in 20 days. The maximum that can be lost if the DIA happens to close at or below $88 per share at August expiration is $302 per contract.

The ETF is currently trading above the break even price of $91.02 per share, so as of now the position is profitable. The Dow Jones Industrial Average needs to rally approximately 1.5% by August 21, 2009 in order for this strategy to reach maximum profitability. This position limits the risk to $3.02 per share. Which if shares of the DIA were purchased a sell off of 3.5% or more on the DJIA index by August expiration would result in a greater per share loss.

Option Spread Strategy #3: Buy the PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQQ) August $38 Call and sell the August $40 Call. The $40 strike call option is factoring in a 41% chance it will expire at or above it at August expiration. If it happens to expire at or above $40, the return from this position would be 68.1% in 20 days. The maximum that can be lost if the QQQQ happens to close at or below $40 per share at August expiration is $119 per contract.

The ETF is currently trading above the break even price of $39.19 per share, so as of now this strategy is also profitable. The NASDAQ needs to rally approximately 1.4% by August 21, 2009 in order for this strategy to reach maximum profitability. This position limits the risk to $1.19 per share.

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. 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.

Out of the three ideas outlined above, I like the NASDAQ option spread idea the most. This market can continue to rally with all the money on the sidelines, but I wouldn't be surprised if it sold off either, as we had a massive rally through July. This is why I am being cautious and limiting my downside to the amounts paid to open these spreads.

Disclosure: No positions

Source: 3 Summer Rally Option Ideas: Large Upside, Limited Downside