Let’s say you are bullish on a $45 stock in the short term. What are your options? You could buy 100 shares outright for $4,500. You could sell a covered call against the stock to reduce your cost basis. But the covered call reduces your potential profit, and if your bullish sentiment is correct, do you really want to reduce your potential profit?
Another option is to buy at the money (ATM) front month calls on the stock. Even if you paid $2 for a front month call option, the most you risk would be that $200 premium per contract. And your maximum gain is completely untapped. If the stock goes to $55, then your ATM 45 strike calls become worth at least $10 each, for a 500% return. Of course if the stock stays at or below $45 into expiration, you also risk losing 100% of your money. But if you have a chance to lose 100% of your money, losing 100% of $200 is better than losing 100% of $4,500. And that is the power of options!
What if you really liked the stock at $45, and were happy to own it at that price eventually, but wanted an inexpensive method to gamble on a potential explosive upside. This is possible, and you can finance part or all of the purchase of your call options by selling naked puts against them. With this method, and depending on the strike prices chosen, it’s even possible to get free call options. Nothing is completely free of course, and every strategy has an associated risk with it. Here is an example scenario.
- Assumption: Stock trades at $45, 45 strike call trades for $2, and 44 strike put trades for $1.50
- Buy (1) 45 strike call for $200 total
- Sell (1) 44 strike put for $150
- Total cost of the trade is $200 – $150 = $50
What are some possible outcomes? – If the stock goes to $50 at expiration, then your 45 strike call is worth $500 and the 44 strike put expires worthless. Your profit is the $500 value of the call minus the $50 to put on the trade, or $450 total profit.
If the stock drops to $40 at expiration, the 45 strike call expires worthless. By selling the 44 strike naked put, you are forced to buy the shares for $44 each, or $4,400 total for 100 shares. At that moment in time, since the shares are only worth $40, then you have a paper loss of $4,400 – $4,000 – $50 = $450. But the original assumption was that you were happy to own the shares anyway at the original price of $45, but wanted to take a short term “gamble” on potential upside first.
By using this strategy, there is an important consideration to keep in mind. Your broker will almost definitely require naked put sellers to maintain cash in their account to cover the full potential loss. By selling (1) contract of a 44 strike put, your broker will likely require you to keep $4,400 cash in your account (referred to as your margin requirement balance) just in case.
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