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Today, let's take a closer look at one of those ideas to see what the potential trade looks like, especially since it just got a few dollars cheaper to enter. Here's a profit and loss graph, courtesy of the broker OptionsHouse. This snapshot was created when the stock was trading around $406.
This strategy involves buying the Jan 375 call for approximately $47 and selling the Jan 425 call for about $20, for the net debit of $27 per share. Since an option contract represents 100 shares of the underlying stock, to purchase one spread would cost $2,700 before commissions.
This graph is based on the potential P&L at expiration on January 21, 2012. If the spread earns the maximum profit of $23 per share, or $2,300 per contract, via the stock closing above the 425 strike at expiration, this will represent a return of 85% on the capital at risk in only 93 days.
What's the maximum capital at risk? The $2,700 initial debit paid to enter the strategy. When you are buying options, your loss is limited in this way. And obviously your gain is limited too since you are short the 425 call option and will receive no further profit potential above there.
Lots of Profitable Scenarios
Notice that the strategy is profitable at expiration simply if AAPL is above $402. And you can exit the spread trade at any time before then and still realize a potential profit.
If the stock goes up to $410 or higher, say in November, you might have a small profit on your hands and you could exit. But your gains in the spread won't be dollar-for-dollar with the stock. Option spreads like this, even with one call "in-the-money", are weighed down by the built-in hedge as the "out-of-the-money" call option you are short rises in value.
If AAPL races above $420 in December, you may have a very nice profit on your hands. But even if the stock goes above the 425 strike to $440, your profit won't be the full $23 per share. It might only make the spread worth $45 with a month until expiration.
This is the dynamic of option time value at work. It's not necessary to understand the mechanics of it here. Just know that these markets are extremely liquid and option prices are very fair at most every point of the trading day because they are in a constant state of efficient valuation based on volatility (the price of risk) and supply and demand.
Billions of dollars are being focused on extracting pennies of efficiency as professional option market making firms and their battling algorithms sort out value through relentless arbitrage and stock replacement.
And Some Losing Propositions
What if AAPL sits around $400 for two months? Well, the value of the spread will fluctuate around some market value near its worth, as it is now. Notice that the spread actually gave you a long, albeit hedged, position in the 375 strike call for less than the call was actually worth.
But as time passes, the value of the spread will even more accurately reflect the worth of the in-the-money call. So it's possible that two months from now, AAPL could be sitting at $400 and you could sell the spread back to the market for nearly the same price of $27 that you paid.
What if AAPL goes down to $380 or lower? The spread will still have value. And that's why you have to decide in advance what you will do if the stock does take a breather and head south before we know how many millions of iPhones the company will sell.
I for one would be looking to add to AAPL long positions on any fear-driven dips to $360 because I believe the stock will be higher than $400 come January earnings.
And the great thing about limited-risk call spreads is that you have very defined, sleep-at-night risk. So you can relax and wait for your scenario to unfold, all the while free to do more research and change your mind at any time.
I use these strategies in AAPL -- and other strong earnings franchises with expensive stocks like Google ( GOOG - Analyst Report ) , CME Group ( CME - Analyst Report ) , Netflix ( NFLX - Analyst Report ) and IBM ( IBM - Analyst Report ) -- because they give me what I want: high returns for comfortable risk.
Kevin Cook is a Senior Stock Strategist with Zacks.com
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