A Strategy For High Probability, Small Gains

There’s an old saying that “slow and steady wins the race.” Of course, there are always different interpretations to these old sayings. But, this bit of wisdom can be applied as investment advice.

Many new traders dream of finding a stock that gains 100% in a matter of weeks and rolling those gains into another stock that delivers a gain of more than 100% within a few weeks. They dream of this process continuing, month after month. And, soon, in their dreams they are living on a private island.

That is certainly a possibility. But, there are other ways to find success in the markets. One path that few seem to dream involves using a small amount of capital to capture a small short term gain. But, if this process can be repeated over and over again, it could provide a path to great wealth.

Finding a Slow But Steady Strategy

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When considering investment strategies, it is usually worthwhile to consider different options strategies. Options are a versatile investment tool that can be used to profit from price increases or declines. They can also be used to find gains in directionless markets. Perhaps best of all, many options strategies can be implemented with just a small amount of trading capital.

Now, there are some strategies that involve seeking large gains in a short amount of time. These strategies include simply buying call options to benefit from a price gain and buying put options to generate gains from a price decline. These are the most common options strategies.

There are other strategies that follow a “slow and steady” approach to profits. Many of these strategies involve debit spreads.

A spread involves at least two different options contracts on the same security. The contracts may have different exercise prices or they may have different expiration dates. Spreads can be created by buying one contract and selling the second contract.

Opening a spread can result in a credit or debit to your account. A credit is earned when the option you buy costs less than the one you sell. A debit is the result when the option you buy costs more than the option you sell. With either approach, a trader is in effect financing at least part of the purchase by selling another option.

For an example of a debit spread, we can consider buying a call option that trades for $2.50. This trade would cost $250 to enter since each option contract covers 100 shares of stock. There is another call option with the same expiration date trading for $2. You could sell that contract, generating $200 in income that can be used to offset the purchase of the first option.

How This Strategy Can Be Used

To understand the potential value of the debit spread, we will consider an actual example rather than theory. Let’s look at a high priced stock, one that many small investors lack the funds to trade. Alphabet Inc. (Nasdaq: GOOGL) was recently trading at about $960 a share. Just ten shares would cost $9,600, a large amount for a small investor to commit to a single position.

Let’s assume you expect the price of GOOGL to rise at least 10% by the end of the year.  This gives you a price target of about $1,056. This is a potential gain of $96 per share.

Buying 100 shares of GOOGL would cost $96,000. This is beyond the reach of many individual investors. You could use a call option to reduce the cost of the trade. A call option gives you the right, but not the obligation, to buy 100 shares of stock at a predetermined price at any time before the expiration date of the option.

An option with an exercise price of $960 and expiring on December 15 is available. This option is trading at about $60. Each contract covers 100 shares which means this option costs $6,000. That is more affordable than 100 shares of the stock but still a lot of money.

Your price target is $1,056. There is an option with an exercise price of $1,060 that also expires in December. That call is trading at about $22. You could sell this option, collecting $2,200 in premium that can be used to offset the purchase price of the first option.

Large Potential Rewards and Predefined Risks

The risks and potential rewards on this trade are defined in advance. The risk is limited to the amount of money you pay to open the trade. In this case, it is $3,800, the difference between the option you bought and the option you sold. No matter what happens, you cannot lose more than that.

The potential gain is the difference between the two strike prices less the amount of the debit. In this trade, the difference between the strike prices is $1,000. Since each contract covers 100 shares, the total gain is equal to $100,000 minus the amount paid or $96,200.

While this is still an expensive trade, it illustrates the potential rewards of debit spreads. This strategy creates opportunities to enjoy large rewards with predefined risks that you establish when you decide to open the trade.

We looked at an extreme example. You could also use this strategy for shorter term options. For example, Microsoft (Nasdaq: MSFT) is priced near $70 and offers an opportunity based on its upcoming earnings report.

MSFT gains an average of 2.8% in the week after its earnings report. With the stock at $70, that provides a price target of about $72.

There is a July option set to expire at the end of the month, about a week after the earnings announcement. The $70 call is trading for about $2. This leaves no expected gains. However, you could buy a $70 call at $2 and sell a $75 call for about $0.25.

This results in a debit of $1 and a potential gain of up to $4. If the stock makes an average move, ending up at $72, you still enjoy a small profit of about $0.25 on the trade. This may not sound like much but is a $25 return on a $500 investment, about 5% in one month. Small debit spreads like these, repeated every month could lead to returns of more than 50% a year.

Benefits of Slow But Steady

Debit spreads can be a great strategy for new traders because the amount of risk is predefined when you enter the trade in dollar terms. No matter what the stock price does, you can never lose more than the amount of money you paid to open the trade.

These trades also require only a small amount of capital. A broker may require a margin deposit equal to the difference between the strike prices. This could be as little as $100 for active stocks and numerous opportunities will be available for trades requiring $250, $500 or less.

These trades also allow you to benefit from up and down moves. A debit call spread would be used when you have a bullish opinion on a stock. A debit put spread can be used when you have a bearish opinion.

Over time, these small trades could have a large effect on your wealth. Because they are short term trades, you could have the opportunity to compound gains several times a year. The gains will be slow at first because the amount risked is small but as the account grows, the steady returns can allow an investor to achieve their goals.