Now, let's take another analogy from real estate. Suppose we are interested in taking a rental of a whole unit with a 2-year contract and then renting it out on a monthly basis at a higher price. We will make money off the difference between the price we paid for the rental and the price we rented it out for. And above all, the initial capital used is much lower than if we were to buy the house outright. But, can this be done with the stocks market? Certainly, it can!
In the options world, this technique is termed as Bull Call Spread. I have illustrated three posts in my blog with regard to this strategy:
Let's make another illustration in continuation of our MSFT example. On 1st Dec 2012, the following are the raw prices for MSFT:
- Price of the underlying stock is at $26.62.
- Price of the long-dated call option (often called LEAPS - Long Term Equity AnticiPation Security) : MSFT Jan15 18 Call is at $9
- Price of the near-dated call option : MSFT Jan13 27 Call is at of $0.64
Unlike covered call, where we purchase the underlying stock before renting out the near-dated call option, the Bull Call Spread strategy replaces the underlying stock ownership by the LEAPS. Thus, we will fork out $900 (instead of $2,660) to buy 100 unit of MSFT which expires on the 3rd Friday of January 2015. This gives us a safety net of 3 years to recover if our decision on MSFT is wrong. Meanwhile, we will again sell the near-dated option to earn us a premium of $64.
Now, let us calculate our return of investment. On 19th Jan 2013, if the price of MSFT is above 27, we will surrender 100 units of MSFT. When this happens, we will pocket $2,700 but will have a short position of -100 units of MSFT because we did not own the stock in the first place. In order to stay in neutral position, we will need to exercise our LEAP call option. For this, we will pay the balance of $1,800. So, in nett, we will earn $2,700 + $64 - $900 - $1800 = $64.(7.11% for 48 days or 54% per annum).
If the price remains below $27 on the expiry date, we can start another round of selling near-dated call options and earning the premium again. We can repeat this again and again until (a) the price goes beyond our near-dated strike price ($27) or (b) we reaches the 3rd Friday of Jan 2015. Suppose that on average, we can sell near dated options for around 4.5% for 30 days. This is equivalent to approximately 54% per annum. Multiply that by 3 years. I will leave this calculation of passive income to be your homework.
Bull Call Spread makes use of leverage. Take note, however, that leverage is a double-edged sword. It helps boost your gains and also worsens your losses.
On a parting note, I urge all my readers to read widely into investment materials to increase your investment knowledge. If you are unsure where to begin, you may take on a few more my recommended books.
Here are the affiliate links to some of the materials I read from: