ETF Options Strategy: Bull Call Spread - ETF News And Commentary

Despite all global headwinds the U.S. equity markets have shown great resilience. In fact the uptrend in equities has proved that considering the present circumstances, equities are still the best place to park money.

Nevertheless, with the Dow surpassing its all time high and the S&P 500 hovering around its high water mark, the question in everyone’s mind is ‘how much more can this continue without a pullback?’ (read Three Most Popular ETFs of February).

Some are starting to believe that a correction is imminent, or at least overdue. But the markets have proved many pundits wrong predicting a pullback in the recent past.

This makes a perfect case to be ‘conservatively bullish’ on the market, especially in the near term. Given this outlook, a Bull Call Spread options strategy on the SPDR S&P 500 ETF (SPY) might be worthwhile, especially given the recent pattern it has exhibited.

As we can see from the chart above the ETF has resumed its upward trajectory as indicated by the green parallel lines after exhibiting some degree of distortion in the latter part of February (red encircled portion). Furthermore it has a strong momentum of 103.62, which has been relatively flat for quite some time (read Can the Dollar ETF (UUP) Finally Break Out?).

These factors could play an important role in the ETF sustaining these levels with a slight bullish bias past the March expiry series.

Strategy

One possible way to play to play these trends are with options. A potential lower risk technique could using a bull call spread on SPY options.

An example of this technique is as follows:

Buy: At-the-Money SPY Call option with a strike price of 155, March 2013 expiry currently trading at $0.71.

Sell: Out-of the-money SPY Call option with a strike price of 157, March 2013 expiry currently trading at $0.13.

SPY is currently trading at $154.82 (i.e. Spot Price).

Payoff

 

Action	Type of Option	Strike Price	Premium	Expiry
Buy	Call	155.00	$0.71	March 2013
Sell	Call	157.00	$0.13	March 2013
Maximum Loss (Risk)				$0.57
Break Even Point				$155.59
Reward				$1.41
Potential ROI				238%
Reward: Risk Ratio				2.38

Payoff Explained

This is a conservative strategy in which both profit and loss is capped. The strategy starts with a first up initial investment of $0.57 per lot which is the difference between the option premium paid on buying, and the option premium received on selling the option.

This also represents the maximum possible loss that an investor can suffer, but only if both the options expire worthless. A loss is realized if the underlying closes below the breakeven point of $155.59 below expiry (read Bet on the Euro with These 3 ETFs).

However, the reward for the underlying strategy could be a handsome $1.41 which can be achieved if the underlying (i.e. SPY) increases to $155.59 (i.e. the break even point) or more from current levels.

Therefore we are looking at less than a one percent increase in the underlying for a 238% return on our investment. This translates into a Reward: Risk ratio of 2.38 times (read Two Amazing ETFs For S&P 500 Exposure).

However, investors should note that the maximum possible gain is limited to $1.42 per lot. Therefore even if the underlying increased substantially more than the break even point, the profit potential for this strategy remains the same.

Additionally, it is worth pointing out that the time until expiration is pretty short and these contracts will need to move favorably very soon. Thus, there is a definite possibility that investors could see a loss with this technique.

But if you believe that the market can continue to surge higher, and if you are seeking a lower risk short-term strategy, a closer look at options could be the way to go for some investors.

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The ideas expressed in this article are for illustrative purposes only.

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