Options Series Part 4
Option Combinations
Usually when we consider an option transaction we look to buy or sell a single strike price. For instance, if we think Gold is going to go to $720 per ounce in the next few months and it is currently trading at $680 per ounce, we would begin to check prices on Call Options starting at the 680 strike and then moving on up until we find one that fits our pocket book. We would also compare the cost of these options for different lengths of time.
For the sake of discussion, let’s say we have $1000 to spend on this investment. We find that we can buy an August 700 call, ($20 out of the money) for $1000. We think Gold will go to $720 but we’re concerned that it might not make it that high before August expires. If it does, our option should be worth at least $2000 (double our money). When we check the price for a December Call Option we can’t find anything realistically close to the current market for $1000.
This is a perfect time to find a combination that will allow us to benefit from the upward movement that we expect. Since the market is currently priced at 680 we look at a December 680 call first. It is quoted at $2650, a price that is way beyond our budget. However, when we look at a December 710 call we see that it is priced at $1850. That means that if we buy the 680 call and then sell the 710 call at the same time, we can apply the $1850 from the sale of the 710 call to the $2650 cost of the 680 call.
By doing it this way we have allowed ourselves to be long an option that is “at the money” ($10 closer to the money than the August) and with a four month longer life than the August. We are also within our budget because the difference between our purchase price and our sell price is only $800 plus two commissions. We still need to predict the direction of the market correctly, but we have increased our odds of winning significantly.
Let’s compare the August 700 call to our combination trade if the market does go to $720 per ounce. The August call at $720 will be worth $2000 plus any time value that is left if it reaches that goal before expiration. $2000 value minus the $1000 cost leaves us with a $1000 return. If time runs out before the market makes its move, the option finishes worthless. If the Gold market goes higher than 720 during the allotted time period, the option will appreciate $100 for each dollar above $720 at expiration.
The Combination, if it expires at $710 per ounce or above will be worth $3000 (the difference between 680 and 710), but no more no matter how high Gold goes. $3000 minus the $800 cost leaves us with a $2200 return. Not only that, but we have had an extra four months to realize our goal and by being able to be long at the money rather than $10 out of the money, our probability of success was greatly enhanced. Finally, the option would only need to expire above $710 per ounce for us to collect the full amount.
This is only one combination in a world of many. There will be more to follow.
There is a risk of loss in trading futures and options. Past performance is not indicative of future results. Stops become market orders once the price is touched or violated; therefore, stops do not guarantee a fill at the price on the ticket. The information and data on this site was obtained from sources considered reliable. Their accuracy or completeness is not guaranteed and the giving of the same is not to be deemed as an offer or solicitation on our part with respect to the sale or purchase of any securities or commodities. Any decision to purchase or sell as a result of the opinions expressed on this site will be the full responsibility of the person authorizing such transaction.