by Jon Najarian

The Bull Spread can be used as an options investment strategy, which, as the name implies, may be used if you have a bullish bias for a stock.  For example, let’s say that you’re interested in the Internet auction company eBay, which was trading at $150 a share.  Buying 1,000 shares would require a staggering investment of $150,000.  Instead, an investor might buy $150 at-the-money calls that expire in two months, and sell the $160 calls against them.  You paid a premium of $11 a share for the $150 calls and collected $8.25 for the $160 calls, for a net cost of $2.75 a share.  On a 10 lot (1,000 shares), that’s a net price of $2,750.

Now, instead of investing $150,000 outright to buy 1,000 shares of eBay, you have a $2,750 net investment.  Here’s what happens under two possible scenarios:

BOUGHT: $150 calls for $11 premium

SOLD: $160 calls for $8.25 premium

Within two months, eBay falls to $125 a share.  The $150 call that was purchased is worthless.  You keep the $8.25 premium collected on the $160 calls.  The net loss is $2.75 a share, or $2,750 – the maximum that can be lost regardless of how far the stock drops.  However, if you had purchased the 1,000 shares outright, you would have lost $25 a share or $25,000 under this scenario.

Let’s say that within two months, the stock trades up to $175 a share.  The $150 calls that you purchased are worth $25, reflecting their intrinsic value (the stock is $25 over the strike price).  Similarly, the $160 calls that you sold are worth $15.  Thus, the spread between those two options has gone to $10 a share or $10,000.  Your net cost, however, was $2.75 a share or $2,750 (which is the maximum you can lose on the trade).  Thus, you’re looking at a net profit of $7,250 – nearly tripling your initial investment amount.  The stock investor, however, made $25,000 which based on a $150,000 outright purchase of shares, is a return of about 17 percent.  So, based on the rates of return and the ability to sleep at night because of a limit on risk, it’s easy to see why options spreads like this one are so popular with knowledgeable investors.

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The advent of high-flying Internet stocks has encouraged the use of options as a speculative vehicle.  Unlike some of the better-known Blue Chips, it’s not uncommon for Internet stocks to trade at $300 or $400 a share, or more.  With this kind of price volatility, it’s no wonder that investors have migrated to options for risk control and capital preservation.  And, as leveraged instruments, options allow you to participate in the upside of a stock (albeit for a defined period of time) for less capital than if you bought the shares outright.

But, there is a mitigating factor (I don’t want to call it a downside), when you use a strategy such as the Bull Spread, and that is the upside is limited by the strike price for the option that you sold.  Using our example of buying $150 calls and selling $160 calls, even if the stock trades at $25 a share or higher, your upside is capped by the differential between the strikes of the two options.  Yet, this seems to be a reasonable trade-off for taking on far less risk than purchasing the stock outright.

The examples we’ve discussed for the Bull Spread have involved fairly static scenarios, meaning you bought a call at one price and sold a call at another and the stock moved in one direction or the other.  But, since the market is constantly moving, you should re-evaluate your position based on your view of the stock.  Still using our eBay example, you buy $150 calls and sell $160 calls about two months out.  Then 10 days later, the stock is at $165.  You’ve made a profit on the $150 calls, but you still have the $160 calls that you sold to consider.  At $165, the $160 calls with a premium of $8.25 won’t be exercised as yet.  But the more the stock moves, the greater the chance you’ll have to deliver shares at $160 if the option is exercised.  What should you do?

It depends on what your outlook for eBay is with the stock now trading at $165.  You may decide that eBay still has considerably more upside and you don’t want your profit limited by this $160 call that you sold.  In this instance, you could buy back the $160 call, and sell as call at a higher strike such as the $170 or $175, or whatever you believe to be a price at or above the upside potential of the stock.

Whatever your decision, make sure you have a plan that includes a price goal for the stock.  If the stock hits or comes close to that goal faster than you anticipated, you have to reassess that plan.  You may say to yourself that based on what you’re reading and hearing about he company’s sales and so forth, you’re very bullish.  Then you re-evaluate your strategy and move your price target.  If there’s nothing compelling to cause you to re-evaluate your previous goal for the stock, then it’s time to exit.

Wall Street’s stars do it all of the time.  A stock moves higher to their price targets and they either suggest investors to take profits and leave, or they move the target higher.  And it’s okay for you, a retail investor, to do the same thing.