The options market provides investors the opportunity to expand on the possibilities present in the stock market. Instead of simply buying or selling, stock price up or down, investors can put on positions that incorporate many different risk/reward strategies that are better at accomplishing certain objectives.
Take Apple, Inc., [$AAPL] for example. Apple has long been a leader in market capitalization, and is one of the most profitable stocks in the entire market for the last 15 years -- a nearly unheard of run of success for a tech company. Investors could have wide-ranging views on the future of AAPL's stock price -- perhaps some believe it's overdue for some poor performance, perhaps investors are confident about the changes in the marketplace and the new products Apple is producing. It's quite fair to say that Apple products are nearly ubiquitous -- the iPhone, iPad, and their laptops are among the most popular products of any kind -- and recently Warren Buffett has placed a large interest in Apple, which can be seen as a positive sign for shareholders.
So let's take a look at a bullish approach. We're going to go on with the assumption that an investor would have a bullish outlook on Apple over the next year. Here are three objectives we'd like to see pursued:
- Make money if AAPL stock continues to rise
- Limit downside risk if the stock falls
- Reevaluate the position after one year
If we were to limit ourselves solely to the stock market, our only choice in this space would be to buy shares of the stock and hold them. The price could go up over the course of the year, but it's unknown by how much. Would we expect AAPL to outperform $SPY? And this carries significant risk to the downside. There's no limit to how far the price could drop, so this wouldn't help us with objective #2 above.
Instead, it would be more beneficial for us to turn to the options market. A long term bull call spread would be a better approach. This strategy enables us to profit to the upside, while protecting us to a limited loss on the downside.
Take the 19-Jan-2018 expiration, for example. This is slightly longer than 1 year out, but the options are available now, and it allows us to benefit potentially from a Christmas rally for the stock during next year's holiday season.
To establish the bull call spread, we'd buy 1 contract of the 100 Strike, which is currently priced at $16.30, and we'd sell 1 contract of the 105 Strike for $13.38. The initial net cost of this trade would be $2.92 per contract -- which equates to $292, as each contract represents 100 shares.
If both the 100 Strike and the 105 Strike were to finish out of the money by expiration, we'd be out $292, regardless of how far the stock price falls. If the stock price expires anywhere above $105.00, both strikes would be in-the-money. The call spread would be worth $5.00 per contract, and after subtracting our initial costs, the result would be a profit of $2.08 per share, or $208.
This represents a whopping 71% return on our initial costs -- and we would see that profit even if the stock price remained unchanged (or down a couple dollars) over the next year. Take a look at the payout diagram below for the payout per contract depending on the final stock price. You can see more payout diagrams by visiting the page on MarketChameleon.com: $AAPL Strategy Payout