FAS and Leveraged ETF Call Spreads

Jan.11.11 | About: Direxion Daily (FAS)

I have been getting a lot of communication from people who believe the market may be approaching a break out and they want to make money on the upside or downside depending on their belief. I like to use a strategy called a LEAP Call Spread (my name for it) or a LEAP Put Spread to significantly reduce my risk of capital and also allow me to get exposure to whatever direction I believe an ETF or stock may be heading. For this article, I am going to use a Bull LEAP Call Spread and follow up with another article to show the inverse trade.

Some of the high volume leveraged ETFs, like FAZ, FAS, QID, QLD, DIG, DUG, SSO and SRS (just to name a few) are very exciting to investors, who see them like dot.com companies in the 1990's, or as a "get rich quick" investment vehicle. I have had many calls to my shows from people who talk about the excitement of owning an investment that could any day skyrocket in value and make them a big return. I don't like most leveraged ETFs, unless you are very good at predicting short-term market direction and can afford to lose all of your money (not too many fall into that category). I have seen a lot of people lose money in leveraged ETFs, so be careful.

LEAPS (Long Term Equity AnticiPation Security) are just longer term options. I like to use options that will expire in 12 months or more for this strategy. Warning: Remember, options are time-sensitive and have an expiration date. Predicting how fast a market will change direction is very difficult, so I want time on my side. I will use FAS and long-term options for a great example of how to put this strategy in play.

At the time of this writing, FAS was trading at $28.89 per share. If I purchase 500 shares of FAS, I will spend $14,445 plus the cost of a commission to buy it. My total risk is the cost of the investment plus commission and my potential profit is unlimited because we have no idea how high FAS could go in a market break out.

For my LEAP call spread, I will purchase the January 2012 Call with a $30 strike price for $7 and I will sell the January 2012 Call with a $40 strike price for $3.80. Remember, options are done in contracts and each contract is equal to 100 shares. If I want to control 500 shares, I need to purchase or sell 5 contracts. Therefore, I will purchase 5 contracts of the $30 strike for $700 per contract x 5 contracts = $3,500. I will then sell 5 contracts of the $40 strike for $380 per contract x 5 contracts =$1,900. In other words, I paid from my account $3,500 for the $30 options I purchased. I then received into my account $1,900 for the options I sold at a price of $40. My total investment at this point is $3,500 minus $1,900 = $1,600.

I have created what traders call a "trade-off". I have greatly reduced my risk of capital from $14,445 with a straight purchase of 500 shares of FAS to just $1,600 with my Bull LEAP Call Spread. This may sound great, but I have also capped my max profit at $10 per share. In other words, the maximum I can make on this trade is the difference between the $30 purchase price and the $40 sell price. Then again, if I risked just $1,600 and make back my max profit of $5,000, I get a return of more than 200% on my money. Not bad.

I like this trade with leveraged ETFs and high-flying stocks because it allows me to participate when I believe a short-term change may be in place, yet my risk of loss is greatly reduced.

I am going to follow this article up with one that will explain when to put this trade on, when to get out of this trade and how to play the reverse side of the trade when you believe the market is going down. Never forget that knowing when to put on a strategy and when to get out is equally important to knowing the strategy itself. Good luck with all your trades.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.