How to Invest/Trade in Under-Priced Companies 2 - Call Spread and Naked Put

There are many variations and various names accompanied to this strategy, but here is one spin on it, which can be added to and developed over time.

The point in this article is about the amount of credit a trader can receive on the initial placement of the trade. The opportunity to receive a credit upfront and further profit from a rise in the share price.

In this example, we are using a 36.50 stock and we are looking at options in the future of about 180 days. We have done our analysis and believe that the stock will rise over the next period of time but with in the 180 days.

We are looking for a credit trade so we will angle the trade like this;

• Sell a Put at $30 with the expiry date 180 days in the future for a credit $0.99
• Buy a Call at $37 with the same expiry date for debit of $3.25
• Sell a Call at $39 with the same expiry date for credit of $2.44

Combined this will give us a total of about $0.18 in credit for the trade. (0.99+2.44-3.25). So that means that as soon as we place the trade we will receive $18 for every contract.

This may not sound like a lot but let us break it all down.

Our risk on this trade is if the share price is below $30 in 180 days time on the expiry date. Based on the individual traders research will determine the probability of this event occurring. Effectively the share price needs to fall about 18% for the trader to question the investment.

Now if the share price rises our profits are capped to the difference between the bought call and the sold call, which is $2. Meaning if the share rockets above $39 and goes to $50 the trader is still only profiting $2 per contract.

The anticipated Margin for this trade is about $430 (rough estimate) meaning the following;

1) When the trade is placed our return on margin is roughly 4%

2) If the market goes above $39 before expiry our profit will increase by $200 making a total return on margin of $218. This is roughly a 50% over 6 months.

If the share price is between $30 and $37 at expiry we make about 4% return anything above $39 the trader, stands to make about 50% return on margin.

If the share price is below $30 on expiry date, the put options will fall in line with the naked put option strategy and a trader will assess the various risks, information and probability etc at that stage.

The benefits of using this style of option trades is that on placement of the trade it makes money. After that, it is up to the market forces which way it will go. If the market climbs, there is a hefty return.

Why not just buy a Call? We will cover this later but the bottom line is the cost. In this example, it would cost the trader $325 per contract, and if the market goes up the trader makes money, but if the market falls, the trader loses money. There is no margin of safety. Doing the trade as per the method noted above, at least there is no upfront cost to the trade, just an ongoing maintenance margin cost, which you get either way.

Their are various ways and strike prices to place the call spread and the put, but the point is to always try to get a small credit for the trade and minimize risk by lowering the naked put. A general rule I use is, the bought call is as close to share price as possible and the short call is about 10% of the share price above the bought call. This is a general starting  guide line and can be modified once the stock and option values are identified.