Google (GOOG) and Apple (AAPL) are among the most popular stocks today. Most individual investors just buy the stock if they think it is going up. But those stocks are fairly expensive. If you want to buy 100 shares, you will have to spend $62,100 on the GOOG stock and $39,100 on the AAPL stock. Let’s see if there is a better way.
Instead of buying the stock, you can buy a call option. Using March 2012 expiration, you can buy the at-the-money (ATM) GOOG 620 call at $38.00 – that’s $3,800 per contract. The cost of this option is 100% time value. The stock will have to rise 6.1% for you just to break even.
If you are bullish on the stock but prefer to guess not where the stock will go to in three months but where it won’t go to, you can use an options strategy called a bullish credit spread. I described this strategy here. It involves selling out-of-the-money (OTM) put and buying further OTM put (lower strike).
You can use this strategy when you believe an underlying security will rise, remain neutral, or fall slightly. If you are right, then the puts will expire worthless since they will be out of the money. Therefore the spread between the prices of the two puts becomes zero. As time passes and the probability that the puts will be worthless increases, the spread will move towards zero.
By looking at GOOG chart, you find out that 200 day MA is around $555. You think that this level provides a decent support and you are ready to bet that GOOG won’t go lower than this price. Based on this conclusion, you can place the following trade:
- Sell 10 GOOG March 2012 555 puts
- Buy 10 GOOG March 2012 550 puts
You will get a credit of $1.10 per spread. Ten spreads will credit your account with $1,100. This is your maximum profit. Margin requirements for this trade are $3,900, so maximum return on margin is 28.2%. The maximum gain is realized if the stock stays above $555 by March 2012 expiration. Based on the short strike delta, the trade has a probability of 88% to expire above $555. This is a 10% downsize protection.
How do we make money from this trade? The trade is theta positive and vega negative. There are three was to make money by March expiration: GOOG goes up, GOOG is unchanged and GOOG goes down no more than 10%. If the stock moves sideways, we make money from the time decay as well as implied volatility drop.
Compare it to buying the calls: you need the stock to move up 6% just to break even. To get the same 29% as with the credit spread, you will need a 8% move. You have to be right about the direction of the move, the size of the move and the timing.
Using the same principle, with AAPL’s 200 day MA around $365, you can place the following trade:
- Sell 10 AAPL March 2012 365 puts
- Buy 10 AAPL March 2012 360 puts
You will get a credit of $1.55 per spread. Ten spreads will credit your account with $1,550. This is your maximum profit. Margin requirements for this trade are $3,450, so maximum return on margin is 45.0%. The maximum gain is realized if the stock stays above $365 by March 2012 expiration. Based on the short strike delta, the trade has a probability of 70% to expire above $365. This is a 7% downsize protection.
The bottom line:
The bull credit spread on GOOG gives you a chance to make 28.2% in three months with probability of 88% and 10% downsize protection if your prediction where the stock won’t be in three months was correct.
The bull credit spread on AAPL gives you a chance to make 45.0% in three months with probability of 70% and 7% downsize protection if your prediction where the stock won’t be in three months was correct.