Fri Mar 27, 2009: Fading the Bounce with Call Spreads

Option investors who think the current stock market rally is about to end might consider writing call spreads as a limited risk way to make that bet.

The table below shows a few possible opportunities, listed in order of their percentage distance out-of-the-money. All of these options expire in three weeks, on April 17th. (You can see the complete table here.)

The JPM 31.00-32.50 call spread is created by selling April 31.00 calls for income and buying the same quantity of April 32.50 calls to hedge, limit the risk, and reduce the margin requirement.

The margin requirement is $113 per spread with a net income of $37 per spread for a total return of 37 / 113 = 32.7% assuming both options expire worthless.

Because this is a low-priced spread, a large enough quantity must be traded to minimize the commission costs, or else the net percentage income will be significantly reduced.

The breakeven point for this trade is $31.37 per share. The risk is a total loss of the margin deposit, $113 per spread, if the stock closes at 32.50 or above.

Comparing this to the other JPM spread in the table, you can see that the percentage income is much higher, 47.1%, and that's the one I would select if I were bearish temporarily on JPM stock, expecting it to decline or stay about the same over the next three weeks.

Until next time, best of luck with your option investments!