p Ken Trester, Managing Editor p Jeff Carter, Senior Editor p Ron Jackson, Publisher

Using Spreads to Buy Options at a Discount
by Ken Trester

"The word 'spread' seems to scare some options players, but a debit spread is quite simple." - Ken Trester 

One lower-risk way to play the stock market is to buy long-term options, or LEAPs. 

A long-term options can be an excellent surrogate for the underlying stock and allows you to participate in the action of the stock for a lot less risk. 

In my research I have found that time is a key to success when you buy options. Long-term options buy you a lot of time, in some cases more than two years. 

And stocks can make gigantic moves over this time period. The major problem with LEAPs is that they are usually quite expensive. To solve this, I suggest that you use what is called a "vertical debit spread". 

A properly designed debit spread has the same limited risk as buying options. LEAP call spreads work best on volatile stocks that have been beaten down or are at the bottom of their trading ranges.

The word "spread" seems to scare some options players, but a debit spread is quite simple. 

The big advantage of a debit spread is that it reduces the cost of the long-term option you are buying. For example, I once recommended a long-term play on Applied Materials (AMAT) when it was priced at 28.

We wanted to buy the AMAT Jan 35 Call at 4-3/4. To offset some of the cost of this option we also recommended selling the AMAT Jan 45 Call at 2-3/8. 

This reduced the cost of the Jan 35 Call to 2-3/8 (4-3/4 minus 2-3/8).

What did we give up by using a debit spread rather than just buying the option? 

Once AMAT crosses the 45 strike price our profit is limited. The gain in the option we bought will be offset by the price rise in the option we sold.  

Your total profit potential is the amount of the spread minus the cost of the spread. So for our AMAT spread our total profit potential is 7-5/8 (45 minus 35 equals 10, minus 2-3/8 equals 7-5/8).

But our maximum risk with this position is what we paid for the spread, 2-3/8. So our potential return is more than 300%. and we have a year for the stock to move.

Debit spreads usually don`t generate maximum profits until expiration or the stock moves deep in the money (in our example, if AMAT moves above 45). So if the spread generates a 100% gain in the first six to nine months, I would take profits. A 100% gain now is better than a possible 300% return in a year.

If the stock moves against you in a debit spread, another good tactical move is to buy back the option you initially sold if it has lost most of its value. 

Then you would own the long-term option without the profit limitations of a debit spread. 

For example, if AMAT drops from 28 to 22 and the Jan 45 Call drops from 2-3/8 to 1/2, you could buy that option back and then own the Jan 35 Call with no limit on possible gains.

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