On February 6, 2011, American Express Company (AXP) closed at $44.82. If you wanted to buy 100 shares of AXP because you felt the stock price will continue to rise, it would cost you $4,482.00 (100 shares x $44.82). You could accomplish the same goal using options but at a greatly reduced cost.
You could buy 10 contracts (1000 shares) of the July 45 call (trading at $2.87 bid / $2.92 ask), a debit and sell 10 contracts (1000 shares) of the July 50 call (trading at $.96 bid / $1.00 ask), a credit. The difference would be $1.91 (2.87 – .96) bid and $1.92 (2.92 – 1.00) ask with 157 days to profit. If you placed an order at a limit price of $1.90, the call spread would cost $1900 instead of $4,482.
BTO 10 AXP Jul 45 call & STO 10 AXP Jul 50 call for $1.90 = $1900 (debit)
You would have the difference of $2,582 ($4482 – $1900) to invest in other stocks or options.
Instead of putting all your eggs in one basket, you have accomplished the same goal (1000 shares) but have money left to invest in other stocks or options and thus minimized your losses.
If the call spread option price rises $.50 to $2.40, you could close the call spread as a unit for a profit of $500 (credit of $2400 – debit of $1900).
STC 10 AXP Jul 45 call & BTC 10 AXP Jul 50 call for $2.40 = $2400 (credit)
If the stock price of AXP drops after the trade, you could buy back the July 50, one leg, for a lower price then you received which is a profit. Then wait for the stock price to correct (rise) and then sell the July 45, the other leg, for more than you paid for a profit on both legs before mid July.
If you choose to close the call spread one leg at a time instead of as a unit, always close your biggest liability first. In this example, it would be the leg that you sold which is the July 50 call.
Remember – Always buy enough time for your strategy to work and use price alerts.
