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OPINION

Highly profitable options

Highly profitable options
January 3, 2013
Highly profitable options

To recap, the FTSE 100 volatility index (VFTSE) was trading around the 16 level on 25 October, up from 11.5 at the end of September, and although it peaked out at 18.76 by mid-November, market volatility subsequently collapsed to a low point of 8.83 a month later as equities enjoyed their customary seasonal pre-Christmas rally.

This is exactly the scenario I had hoped for when I recommended using traded options as a way of exploiting the pick-up in market volatility and maximising returns from index trades in the final quarter of 2012. It has also reaped bumper returns because with the FTSE 100 expiring at 5909 at 10.15am on Friday 21 December, I made a 38 per cent return on my trade in only eight weeks. This compares rather favourably with the 1.3 per cent rise in the index which rose from 5832 to 5909 in the same eight week period.

Moreover, I have devised another short term trade using the same ‘buy-call spread trading strategy’ on the FTSE 100 which potentially could make similar impressive returns in the coming weeks even if the market barely moves. Here’s how it works:

Buy-call spread trading strategy

There are two parts to my trade. First, I select an 'in-the-money' call option with the highest strike price possible, but with virtually all the option price as intrinsic, rather than time value. I then simultaneously sell a call option with the same expiry date but with a higher strike price, and one that is 'out-of-the-money' so all the premium I receive is time value. In effect, what this means is that if the FTSE 100 doesn’t rise at all by the time the call options I purchase expire, but equally doesn’t fall either, then I lose very little capital through the erosion of time value on the options purchased. And because the options written expire worthless to the option buyer, the option premium received provides a healthy profit on my net investment.

Similarly, if the FTSE 100 rises by the time the options purchased expire, the increase in the value of the calls options purchased will match the rise in the index point-for-point, and completely offset the loss made on the call options written. Even in a worst-case scenario where the FTSE 100 falls below the exercise price of the call options purchased, then at least the premium received on the options written would offset some of the loss on the options purchased.

First quarter rally

As I outlined in my UK stock market outlook in our Christmas edition I am maintaining my bullish stance on the equity markets and expect the fourth quarter rally to continue for the coming months at the very least (Reasons to be bullish, 21 December 2012). That’s reason enough to run your profits if you followed my previous advice to play the Christmas rally (A lesson in Zirp, 26 November 2012). To recap, I advised buying the FTSE 100 on Tuesday 11 December at 5922, with a view to banking profits in early January, so we are comfortably in profit on this trading position with the index currently trading at 6033.

But there is an even smarter way of playing a likely first quarter rally rather than taking an outright spread bet on the market. That’s because I can build in a hefty safety net by adopting my favoured buy-call spread trading strategy here too. Let me explain.

With the FTSE 100 volatility index (VFTSE) currently around the 14.5 level and the FTSE 100 trading at 6033 on Thursday 3 January, I am able to buy the FTSE 100 call options with a 5800 exercise price and 15 February 2013 expiry date for only 255p, or the equivalent of 255 index points. In other words, 233p of the option price is 'in-the-money' and only 22p, or the equivalent to 22 points on the FTSE 100, is time value which will erode in the six weeks between purchase of the options and expiry on Friday 15 February. By contrast, the FTSE 100 call options with a 6050 exercise price are priced at 79p, or the equivalent of 79 index points, all of which is time value since their exercise price is above the current level of the FTSE 100.

So my trading strategy is simple: buy the FTSE 100 February 5800 call options for 255p and at the same time write the 6050 call options to pocket the 79p option premium. This significantly lowers my net investment to 176p – the difference between the two option premiums - and provides a safety net on this short-term trade as I am in effect long of the FTSE 100 at 5976, or 57 points below the index at the time of entering this trade.

Profitable options

To illustrate how the vertical buy-call spread option works, consider the following scenarios when the options expire on Friday 15 February:

■ FTSE 100 closes unchanged at 6033. The FTSE 100 February 5800 call options are settled at 233p and you lose 22p on these. However, the February 6050 options expire worthless so you pocket all of the 79p premium received on these options to make an overall 57p net gain, or a 32 per cent net return on the 176p invested.

■ FTSE 100 closes above 5976 but below 6050. For every point the index rises above 5976 you make an additional 1p profit on each option purchased. So if the index closes at 6050 at expiry the FTSE 100 February 5800 call options will be worth 250p (or 5p less than you paid) and the February 6050 options expire worthless so again you pocket all of the 79p premium written. Overall, this means you would make a net 74p gain, or a 42 per cent net return on the 176p invested.

■ FTSE 100 closes above 6050. The profit on the February 5800 call options matches exactly the loss you would make on the February 6050 options written for every point the index rises above 6050, so you are still guaranteed to make a 42 per cent profit (as above) on this trade even if the FTSE 100 soars.

■ FTSE 100 closes below 5976. This is the break-even point on this trade and for every point the index is below 5976 at expiry you will lose 1p of the 176p net investment. For instance, if the FTSE 100 closes at 5900 at expiry the February 5800 call options will be settled at 100p – 155p below the price paid – which is offset by the 79p premium received on the February 6050 options written. So you would make a loss of 76p, or 43 per cent on the 176p net investment.

Please note you lose all your 176p net investment if the FTSE 100 closes below 5800 at expiry of the call options on 15 February.

Execution of strategy and risk warning

Clearly you should only put a small amount of your capital into leveraged investment products as these carry far greater risk. But it’s also worth bearing in mind that this trading strategy is offering up an attractive 42 per cent profit on our invested capital assuming the FTSE 100 is trading above 6050 in mid-February. It also has potential to produce a 32 per cent net gain even if the FTSE 100 fails to make any headway from the current 6033 level over the next six weeks and has an automatic safety net built in to protect us against the first 57 points fall in the index before we would incur a loss on our invested capital.

Executing traded options strategies

These traded option strategies are pretty easy to execute as there are several brokers accepting retail clients. These include Sucden (www.sucden.co.uk), Rensburg (www.rensburgsheppards.co.uk) and stockbrokers such as Charles Stanley (traded options department direct line is 0207 667 2288).