Written on 15th February 2008 (see below for further updates)

I thought I’d provide an example of a Bull Call Spread (BCS) using the Commonwealth Bank as an example. There is a lot of volatility in the market at the moment. If you have studied my course then you will know that high volatility is a great advantage for the Option Seller – a decrease in implied volatility means a decrease in the Option premium – but let’s get back to this example!

Since making a high around $62.00 in November 2007 CBA has spent the last few months falling to its current price of $47.00. Can it go lower? Is this the bottom? I have no idea! Instead of buying the stock and watching it plummet even lower let’s look at a strategy where we know EXACTLY what our MAXIMUM risk and MAXIMIM profit is – a Bull Call Spread.

When you BUY a CALL Option your view is that the underlying Stock will rise. So with CBA closing last night (14th Feb) at $47.05 you might to decide to BUY a CALL Option with a Strike price of $48.00 that expires on the 27th March 2008. The quoted price for this option is $1.69. If you bought 2 contracts it would cost you 2,000 @ $1.69 = $3,380 (plus brokerage). In 10 days time if the stock price increased by 4% to $48.93 the Option price would be somewhere around $2.15. You could then Sell the CALL Option and profit $920 or around 27%.

To reduce the cost of Buying the CALL Option you can SELL a CALL Option at a higher strike price. Building on the above example you would SELL 2 March CALL Options at a strike price of $51.00 and receive a premium of $0.71 which means you receive 2,000 @ $0.71 = $1,420. So your total cost would be the price that you paid for the contracts that you bought ($3,380) less the money that you received for the Options you sold ($1,420). Total Cost $1,960.

The advantage is that you are reducing the cost of entering the trade. The disadvantage is that you are limiting your profit to the upside if CBA trades above $51.00. I like the Bull Call Spread trade because you know your maximum profit and maximum loss before you enter the trade. The best way to view this is via a picture (listed on the next page).

Please note that this trade is purely for educational purposes only. I’ll send an update of this trade in a week or two to see how it would be progressing. If you have any questions you are more than welcome to send me an email glenn@optiontrader.com.au.

Cheers

Glenn Dove

www.optiontrader.com.au

Update written on 22nd February 2008

It’s always worth reviewing your trades especially when you trade Options. One week ago I provided an example of a Bull Call Spread Option strategy on CBA shares. At the time of the Option trade CBA was trading @ $47.05 and we had entered a long position.

How would we be going on the 22nd February with the price of CBA trading at $42.40?

The trade has not gone in the direction that we wanted but there’s a lot we can learn from this type of strategy. The Bull Call Spread (BCS) that we entered entitled us to Buy 2,000 CBA shares @ 48.00 and to sell 2,000 CBA shares at a maximum price of $51.00 anytime before 27th March. The total cost of the BCS position was $1,960.

So what’s so good about that?

• We are in control of $96,000 of CBA shares (2,000 @ $48.00) and it only cost us $1,960 to enter the trade. This works out to around 2% of the total trade value.

• We are limited to a maximum loss of the premium that we paid $1,960. If we had of bought 2,000 CBA shares at the market price (on 15/2) we would have paid $94,100. With the current price of CBA at $42.40 we would be sitting on a paper loss of $9,300.

So as you can see even though the trade has not gone in the direction that we wanted the BCS has provided great leverage while limiting our loss potential to only 2% of the trade value. Also remember that we still have until 27th March for this trade to work. You could also decide to close the position if you thought that the CBA had no chance of getting back above $49.00 by the 27th March which would leave you with a loss of $1,297.

It’s also worth mentioning some of the disadvantages even though I believe the advantages far outweigh the disadvantages:

• If there are any dividends payable during the Option period we are not entitled to them (as we don’t really own any shares)

• We have a limited time (until the Option expiry date) for the trade to become profitable. Once the contracts expire they become worthless.

• Our profit potential is limited due to the fact that we SOLD Option contracts to reduce the cost of the Options that we bought.

If you have any questions send me an email: glenn@optiontrader.com.au

Cheers

Glenn Dove