Up to now, I have written three articles extolling the virtues of stock options in your investment portfolio. The first discussed how selling call options against your existing stock position lowers the cost of your stock investment and creates dividends out of thin air. The second explained how selling put options allows you to purchase stock at a discount. And the third demonstrated how buying a long-term call option as a stock replacement can provide you with all the upside of stock ownership but at a fraction of the cost of stock ownership.

Option Spreads Reduce Risk Even More

Do you see any pattern here? In each case, options are used to lower your out-of-pocket cost and thereby reduce your risk. But there is yet another step you can take with options to reduce your risk even further. It is a secret that option professionals have been using for decades but which has only recently entered the mainstream. This extremely powerful tool is known as spreading.

Making an Example of IBM

Here’s how it works using my all-time favorite stock example: IBM (NYSE: IBM). It’s a good stock to use for options illustrations because it is very liquid, as well as high-priced so that it provides many different strike prices to choose from. And it doesn’t hurt that it is also currently one of Elliott Gue’s top growth stock recommendations in his Personal Finance investment service.

Anyhoo, let’s say you’re a Personal Finance subscriber who agrees with Elliott on IBM’s bullish prospects. With IBM trading at $130 a share, you don’t want to risk a large amount of your capital buying stock, so you decide to buy a call option that expires in January 2011 as a stock replacement. According to Elliott, IBM is a buy up to $135, so assuming that Elliott’s recommendations are expected to make a minimum of a 15% profit, that means that IBM is worth about $155 (1.15*$135).

Using Calls as a Stock Replacement is the First Step

One possibility would be to simply buy the $130 call, which currently costs $9.30 per share or, because one options contract equals 100 shares, $930 per contract. Buying 100 shares of IBM stock would cost $13,000, which is quite a bit bigger capital commitment than the $930 needed to buy the equivalent options position, wouldn’t you say?  At January expiration, break-even for the options position is $139.30 ($130 strike plus $9.30 option cost). If IBM makes it up to the $155 target by then, the call option contract will be worth $2500, resulting in a profit of $1,570 or 169% ($1,570/$930).

In contrast, the buyer of 100 shares of IBM stock at $130 would make a profit of $2,500 but only a 19% profit ($2,500/$13,000) because of the much higher capital commitment involved in buying the stock. The option buyer could easily surpass the stock buyer in dollar profit simply by purchasing two $130 call options instead of one. This would double the option cost to $1,860 but would still cost 85% less than buying the $13,000 worth of stock. 

Converting Calls into Call Spreads is the Second Step

But in my world of maximum risk reduction, even 85% less is still too expensive, still too much risk. Consequently, I recommend selling the $135 call against the purchased $130 call – thus creating the 130/135 call spread — in order to reduce the cost of the bullish position even further. As I explained in Create Dividends Out of Thin Air, an option is a derivative contract that can be sold without owning it. The $135 call is trading at $6.90 per share ($690 per contract), so selling it against the $130 call would reduce your overall cost to $240 per contract ($930-$690), a 74% reduction from the original cost of $930 for the $130 call alone. 

Sound Familiar?

If the mechanics of creating this call spread sound vaguely familiar, you’re not imagining things. It’s very similar to the covered call strategy I discussed in Create Dividends Out of Thin Air. The only difference in the case of the spread is that you are selling the covered call against another call rather than against stock. The risk reduction benefits are simply magnified many times over in the option spread situation, since the sale proceeds of the call you are selling ($690) is much closer in value to the call you purchased ($930) than to the value of the 100 shares of stock you could have purchased ($13,000).

I’ll Sacrifice Huge But Unlikely Upside for Regional Leverage Any Day

As in the case of a covered call strategy, the “catch” is that you limit your potential upside profit in the stock. In the case of the 130/135 call spread, your maximum profit at expiration occurs at $135; any further appreciation in IBM’s stock price above $135 is collected by the purchaser of the $135 call you sold.  But the cost reduction you enjoy by selling the $135 call is so great that the profit potential remaining is tremendous:

$130/$135 Call Spread on IBM: Profit/Loss at January Options Expiration (1-22-11)

As the table shows, the call spread is the superior investment at all price levels under $149.34 on a percentage profit basis and under $141.90 on a dollar profit basis. What’s so impressive about the spread’s profit outperformance is that it occurs while reducing risk at the same time! Between IBM’s current price of $130 and $141.90 (9.2% higher), the spread makes more money on a dollar basis than the individual call and yet requires 74% less of a capital commitment.

Because the outperformance of spreads is limited to cases where the stock rises only modestly, option traders often characterize spreads as possessing “regional leverage.” Within the region of modest price appreciation, the spread can’t be beat, but individual calls will outperform in cases where the stock makes a huge price move. But isn’t it better to bet on modest price moves than huge price moves?  You betcha.

I especially like the comparison at the $135 stock price. The spread more than doubles your money while the individual call loses 46%! Amazing. The stock only has to increase by 3.8% for the spread to gain 108%. Now that’s what I call leverage! Financial theory always teaches us that to get more reward you need to take more risk. This options spread illustration belies that notion; you can have your cake and eat it too! 

Maybe Worth a Try

If you are very bullish on a stock, simply buy an individual call option. If, however, you are only moderately bullish on a stock and think it will go up some but not a lot, buy a call spread. Substantially reducing your out-of-pocket cost while at the same time substantially increasing your profit potential makes a lot of sense.