(CHK) Legging Into a Spread: An Option Strategy That Makes The Market Pay You

October 27th, 2009

by Karim Rahemtulla, Advisory Panelist
Friday, October 23, 2009: Issue #1122

It’s always rewarding to notch up a big win on a trade – be it a stock, option, or otherwise. But before you pull the trigger, consider that you may be leaving money on the table.

However, there is a way to take an ordinary profit and supercharge it into a blockbuster return. We’re talking about the kind of return that bags you not just a few hundred percent… but a few thousands of percent.

As someone who primarily trades options – and shows investors how to use the most lucrative options strategies (together with specific recommendations) – I’ve seen this happen numerous times over my 20-plus years of investing experience.

So can investors incorporate quadruple-digit winners into their portfolio? In my last column, I showed you how to execute a spread trade. This is where you buy one option and sell another one against it, thereby reducing your cost and increasing the return on your invested capital. And while your upside is capped, your downside is protected, too.

Now, I am going to take you one step further, using a real-life example that I recommended to readers of my 400 Report service, the strategy is called “legging into a spread.” Stick with me here – it’s not confusing…

How Legging Into a Spread Works

“Legging into a spread” works just like a regular spread trade in that you sell an option against one that you already own. However, the difference is that you don’t sell an option right away… you do it after you already have a sizeable gain in your current trade.

And here’s the best part: Using this strategy, you will be able to reduce your cost to $0, or even have a negative cost, and the market will be paying you to be in the trade. Furthermore, you’ll increase your upside potential on the trade as well.

Here’s how it works…

Once we had decided to play the oil and natural gas firm Chesapeake Energy (NYSE: CHK), we did the following…

~ Bought the $12.50 call options, with 15 months until expiration. For that, we paid $1.20 per contract. (One contract = 1,000 shares)

When Chesapeake shares moved to the $14 level, our call options rose significantly. While this was obviously a positive development, it wasn’t really relevant to what we wanted to do. We could have taken our profits and moved on, but we decided not to.

Instead, we did this…

~ Because Chesapeake shares were rising, the decision to “leg into a spread” was easy. So we looked at the $15 call options, trading for $1.15 per contract, and sold them against the $12.50 ones that we bought. When you sell anything, including an option, you immediately receive money in your account.

Legging Into a Spread: Grab a 5,000% Return With Just $500 at Risk

Let’s break down this “legging into a spread” example to work out the profit…

Let’s say we bought 100 contracts of the $12.50 call options at $1.20 per contract. This represents 10,000 underlying shares of Chesapeake, since there are 100 shares in each options contract. This cost us $12,000 (10,000 shares multiplied by $1.20 = $12,000).
However, when we sold 100 contracts of the $15 call options for $1.15 each, we received $11,500 back into our account (10,000 shares multiplied by $1.15 = $11,500).
Risk: That leaves us with a net outlay of $500. So if we held the position to expiration, our maximum risk is $500.
Profit: By selling the $15 option, our upside is $2.50 ($15 minus $12.50), based on the spread. So if Chesapeake closes at $15 or higher at expiration, the most we can make is $25,000 in gross profit ($2.50 multiplied by 10,000 = $25,000) and $24,500 in net profit, given our net outlay of $500.

In this real-life trade, Chesapeake did indeed close above $15 at expiration, meaning we made $25,000 for every $500 at risk – gains of close to 5,000%.

Equally important, though, was the fact that we limited our risk from the $12,000 that we originally invested to just $500.

This type of trade is not unusual. In my 400 Report advisory, we have three other current trades just like this one, the mechanics of which are all the same. If you’d like to get more information on these trades – and all the others I recommend to my readers.

The bottom line is this: If you have profitable options trades in your portfolio, you should always consider “legging into a spread.” The only prerequisite is that you need to allocate enough time for the shares to move higher – something that is possible when you trade long-term options.

Good investing,

Karim Rahemtulla

View original at: Investment U