But for now, equity markets should continue their relief rally as investors bet that the Eurozone leaders will come up with a solution to the debt crisis in the region, albeit one that is unlikely to prevent the next leg of the bear market unfolding next year. That's because the deleveraging of the banking sector has a long way to go and, coupled with a Eurozone recession, we will be faced with a credit crunch at the same time that earnings and margins are coming under pressure.
However, to capitalise on the FTSE 100 holding its ground over the next six to seven weeks I have devised a low risk trade by using a vertical spread trading strategy through the London traded options market. Last year, I explained how to use buy-call spread option strategies (Triple Witching Profits, 1 March 2010) and very profitably, too. They are pretty easy to execute as there are several brokers accepting retail clients including Sucden (www.sucden.co.uk), Man Financial Global Direct (www.mfglobaldirect.co.uk) and Rensburg (www.rensburgsheppards.co.uk).
Buy-call spread trading strategy
There are two parts to this trade. First, 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. Then you sell a call option at a higher strike price, and ideally as close as possible to the current index level, so all the premium received is time value. In effect what this means is that if the FTSE 100 doesn't rise at all by the time the options expire, but doesn't fall either, then you are losing very little capital through the erosion of time value on the call options purchased. And because the options written will expire worthless to the option buyer, the option premium you received will provide a very healthy net profit on your net position.
Equally if the index rises then the increase in the value of the call options purchased will match the rise in the index point-for-point, and will completely offset the loss made on the call options written. And even in the worst case scenario, if the FTSE 100 falls in value below the exercise price of the call options purchased, then at least the option premium received offsets the loss on the options purchased.
To see how this works in practise, consider the call options series on the FTSE 1000 which expire on 16 December 2011. With the FTSE 100 trading at 5500 on Monday 17 October, the call options with a 5000 exercise price are priced at 560p, or the equivalent of 560 index points. In other words 500p of the option price is in-the-money and only 60p, or the equivalent to 60 points on the FTSE 100, is time value so will erode between now and expiry of the options in December. By contrast the call options with a 5500 exercise price are priced at 220p, or the equivalent of 220 index points, all of which is time value.
So the idea is to buy the FTSE 100 December 5000 call options at 560p each and simultaneously write the 5500 call options to pocket the 220p option premium. This in effect significantly lowers your entry point to 340p and also provides a safety net on this short-term trade as you are in effect long of the index at 5340, or 160 points below the current index price.
To illustrate how the buy-call spread option works, consider the following scenarios when the options expire in mid-December:
■ FTSE 100 is at 5500. The FTSE 100 December 5000 call options are worth 500p and the December 5500 options expire worthless so you pocket the 220p premium on these to make a net 160p gain, or a 47 per cent return in only two months on the 340p invested. In fact, you will make this same return even if the FTSE 100 is above 5500 at expiry.
■ FTSE 100 rises from 5500 to 5720. The December 5000 call options are worth 720p and the December 5500 options expire at 220p – the same price you wrote them at. This again produces a net gain of 160p (all of which came from the 5000 call options) on the 340p invested, or the equivalent of a 47 per cent return in only two months.
■ FTSE 100 is below 5500 and above 5340. The December 5500 call options expire worthless and the 220p option premium received offsets all of the loss on the December 5000 call options purchased. As long as the index stays above 5340 you make a profit equivalent to 1 per cent of your 340p net premium invested for every 3.4 points rise on the FTSE 100 above 5340.
■ FTSE 100 is below 5340. You make a loss equivalent to 1 per cent of your 340p net premium invested for every 3.4 points fall on the FTSE 100 below 5340. So if the index falls back to 5200 by mid-December, the December 5000 calls options will expire at 200p and you make a 140p net loss on the 340p net investment.
The beauty of this strategy is that we can book profits at any time simply by selling the December 5000 call options in the market and buying the equivalent number of December 5550 call option to reverse the position on the options written. Moreover, this strategy can produce a 47 per cent net gain even if the FTSE 100 fails to make any headway over the next six to seven weeks.
