Secret 72HOW TO REDUCE THE COST OF OPTION BUYING
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Spreading is an excellent way to reduce the cost of an option
purchase. This spread is usually called a debit spread. To design
the spread, you buy one option and write another option against
that position, either at a different strike price (a vertical spread)
or expiration month (a calendar spread).
Vertical spreads work well for reducing the cost of the position
but limit your profits so that you can’t hit home runs. They
work best when at-the-money options are less expensive in comparison
to their out-of-the-money options. That can be measured
by calculating the implied volatility of each option. For example,
if the implied volatility of the option you are purchasing is 30%,
but the out-of-the-money option you are writing has an implied
volatility of 40%, you have a good play.
Here is how a spread works. If you bought the PFE Jan 40
call for 2, you could offset the cost of that option by writing or
selling the PFE Jan 45 call for 1. Now the cost of your position is
only 1 point instead of 2, but you cannot profit beyond 45.
Altogether, your risk-reward picture looks like this. You risk
1 point to make a 5 point gain (45-40=5), less the cost of the option
you bought; your maximum profit is 4. Here you have a potential
400% return on your investment.
Running a probability analysis will also help you decide
whether you have a good trade or not, and, as previously mentioned,
measuring the implied volatility of both options will give
you some valuable input. The beauty with these spreads is that
you can not lose more than you paid for the spread, and that is
also your margin requirement.
Spreading is an excellent way to reduce the cost of an option
purchase. This spread is usually called a debit spread. To design
the spread, you buy one option and write another option against
that position, either at a different strike price (a vertical spread)
or expiration month (a calendar spread).
Vertical spreads work well for reducing the cost of the position
but limit your profits so that you can’t hit home runs. They
work best when at-the-money options are less expensive in comparison
to their out-of-the-money options. That can be measured
by calculating the implied volatility of each option. For example,
if the implied volatility of the option you are purchasing is 30%,
but the out-of-the-money option you are writing has an implied
volatility of 40%, you have a good play.
Here is how a spread works. If you bought the PFE Jan 40
call for 2, you could offset the cost of that option by writing or
selling the PFE Jan 45 call for 1. Now the cost of your position is
only 1 point instead of 2, but you cannot profit beyond 45.
Altogether, your risk-reward picture looks like this. You risk
1 point to make a 5 point gain (45-40=5), less the cost of the option
you bought; your maximum profit is 4. Here you have a potential
400% return on your investment.
Running a probability analysis will also help you decide
whether you have a good trade or not, and, as previously mentioned,
measuring the implied volatility of both options will give
you some valuable input. The beauty with these spreads is that
you can not lose more than you paid for the spread, and that is
also your margin requirement.