The high cost of buying an outright call or put option on many markets makes ownership quite expensive and in most cases a bad bet unless held for a short
period of time
. The vertical spread is my first choice in placing a bet on which direction the market will go. That is a great strategy to use when you feel the market can move significantly in one direction; but to capture a larger profit on a bigger move, the vertical sp
read becomes expensive as well.
The next strategy to look at is the butterfly spread (the Fly). The Fly spread lowers the cost of buying an outright option when you need more than three months until expiration. The ultimate goal of this spread is to forecast where the market will be at expiration. If correct, the reward is great; if partly right, the reward is very good; and if barely right, you still get even money. If wrong, you know
exactly what your risk is and the exact amount you will lose
.
The other benefit of this spread is that in any major move against your position, you still have time for the market to do what you thought. No
need to become emotional or be forced to exit your trade before you decide
whether your market
projections are still valid.
The simplest way to look at this spread is to understand that it is two vertical
spreads
. One spread you buy and one spread you sell. Here is one example:
March ‘08 crude oil settled at $96.05 on Nov. 23, 2007, its options expire on Feb. 14. The March 95 call settled at 586 ($5,860 at $10 per tick), the 100 call settled at 373 and the 105 call settled at 229.
Buy 1
CLH8
95
call
@586
Sell
1
CLH8
100 call @373
On Nov.
23
you would have paid 213 ($2,130) for the 95/100 vertical call spread. Now:
Sell
1
CLH8
100 call @373
Buy
1
CLH8
105 call @229
You would have collected 144 ticks. Your total cost (not including fees) for the 95/100/105 Fly on Nov. 23
is $690 (213-144= 69 or $690).
This strategy is reflective of the opinion that on expiration, March crude oil will be trading at $100. If correct, you paid $690 plus commissions and it is worth $5,000. Almost a
6
to 1 risk/reward, and if you use a $340 sell stop, a 12 to 1 risk/reward. If oil settles at $98.50, it would be worth 350 ticks ($3,500), about 4 to 1 after paying commissions.