By: Chuck Hughes
In this article we focus on strategies that help us increase the profit potential and help protect profits for ETF and ETF option purchases. In today's fast moving markets it is important to protect profits for profitable ETF and ETF option purchases:
1) Take profits on part of your profitable ETF or ETF option positions.
2) Sell an option to create a spread on profitable ETF or ETF option positions
We covered taking partial profits on profitable ETF and ETF option positions in Chapter 2 - Trade Management Guidelines. Now let's explore selling options to create spreads on profitable ETF and ETF option positions. Selling options to create spreads not only helps protect profits but has the added benefit of increasing the profit potential of existing trades. Let's take a look at an actual trade example to help us understand this important concept. Click here to learn more about call option.
In 2006 the China ETF was in a GPS Major Trend System price up trend. My brokerage confirmation below shows that in December 2006 I purchased 10 of the China ETF (FXI) January 90-Strike call options symbol YOFAW in increments with an average price of 17. 44. These options expire in 13 months. I then sold 10 of the China ETF (FXI) January 120-Strike call options symbol YOFAD at 8. 00 points on May 11th. The sale of the 120-Strike call options created a bullish option spread that increases the profit potential of the 90-Strike call options purchase and also provides down side protection in the event the China ETF increases in price. Although this is a longer term trade this spread can be closed out to take profits anytime before option expiration. As noted previously I normally will take profits on a spread trade if the spread reaches about 90% of its maximum profit potential.
The Spread Analysis below displays the profit potential for buying the China ETF January 90-Strike call option for 17. 44 points and selling the January 120-Strike call for 8. 0 points. The Analysis displays potential profit results for various price changes for the China ETF at option expiration from a 10% increase to a 10% decrease in price. The China ETF was trading at 115. 90 when the spread was created. The cost of this spread is 9. 44 points or $944 and is calculated by subtracting the 8. 0 points I received from the sale of the 120-Strike call from the 17. 44 cost of the 90-Strike call purchase. The maximum risk on this trade is the cost of $944.
The Spread Analysis reveals that if the China ETF price remains flat at 115. 90 at option expiration a 174% return will be realized (circled). A 10% increase in price for the China ETF to 127. 49 results in a 217. 8% return and a 10% increase in price to 104. 31 results in a 51. 6% return (circled). The maximum profit potential of 217. 8% for this spread is reached if the China ETF closes at or above 120 at option expiration which is the strike price of the short call.
I purchased the China ETF 90-Strike call in December. The price of the underlying China Fund ETF continued to move up in price after the purchase and by May 11th the 90-Strike call purchase had a 9. 70 point open trade profit when I sold the 120-Strike call to create the spread.
When I sold the 120-Strike call the China ETF was trading at 115. 90. The 120-Strike call, therefore, was an out-of-the-money call as the strike price was higher than the current price of the ETF. Out-of-the-money calls consist of only time value and no intrinsic value. When you sell an out-of-the-money call the full value of the premium in this example 8. 00 points becomes all profit at option expiration as options lose all time value at expiration. So the sale of the 120-Strike out-of-the-money call increases the profit potential of the 90-Strike call purchase by 8. 00 points regardless of the subsequent price movement of the China ETF.
Increased Profit Potential by 82% and Reduced Risk
On May 11th the existing 90-Strike call purchase had a 9. 70 point open trade profit so the sale of the 120-Strike call increased the profit potential of the call purchase by 82% (8. 00 points/9. 70 points = 82%). In addition to the increased profit potential the sale of the 10-Strike call also reduced risk by providing downside protection for the 90-Strike call purchase in the event the price of the China ETF declined. Creating spreads with an existing option purchases increases the profit potential and reduces the risk of the option purchase. This provides one of the best overall risk/reward profiles compared to any other strategy. For more info visit option trading.
Note: In this example we used a bullish option spread. The same advantages of creating a bullish option spread would also apply to bearish options spreads.
By: Chuck Hughes