About a year ago, I felt certain that the broad market had lots of upside left even after the excellent runup that occurred over the prior 3 years. I based this largely on the low valuations I was seeing relative to earnings and also on the bearish sentiment I was seeing all around me. (Note: I’m a big advocate of the contrarian school of thought that says if the crowd is positive on the market, there are no buyers left, and in this case….vice versa.) I was willing to bet that a healthy rise was going to occur. However, I still had linger fears of external events rocking the markets related to the war in Iraq or unforeseen terrorist actions.

So…….I wanted to take a position that had limited loss but would profit from a healthy runup. I decided to base my predictions on the S&P 500 and its mirroring ETF called SPY. For those not familiar, SPY is traded like a stock and is priced roughly at 1/10 the price of the S&P 500 index. So, at that time when the index was 1250, SPY sells for 125. I decided that I was willing to bet that SPY would exceed 140 within a years timeframe.

After doing some research I decided a Bull Straddle was the bet that I wanted to make. A bull straddle provides limited loss at the low end, limited gain at the high end, and graduated profits in the middle. A bull straddle involves selling (short) a call option at one strike price and buying (long) a call option for a higher strike price. Here is a graph of the profit for a Bull Straddle.

If the price of the entity, in this case SPY, goes above the higher strike price, the value of the two positions will be the difference in the strike prices minus the difference in the options’ purchase prices. If the price of the entity (SPY) hovers near the lower strike price, the value of the two positions will be the same as if the SPY was worthless….that is the loss will be the difference in the original purchase prices.

Here’s the position I took last year. I sold a Jun 2007 130 call option (for $270 per contract) and bought a Jun 2007 140 call option (for $760 per contract). (Note: an option contract represents 100 shares.) My maximum loss per contract would then be $760-$270 = $470. My maximum gain per contract would be $1000 (100 times the $10 difference in strike prices) minus the cost difference of $470 which comes out to $530.

Well, fortunately I was right and the S&P 500 has risen above 1400 (it is at 1490 as I write this). I could wait until the expiration date (3rd Friday in June) and if the price doesn’t change I would lock in my $530 per contract. However, I decided to take the position off the table today. Since there is still a time element left (the S&P 500 could crash between now and June), I will get something less than the full $530. Today I sold by long position for $17.10 per contract and closed my short position for $5.80 per contract for a grand total net profit of……$370 per contract. It was a valuable experiment. I felt I played a relatively safe position given the loss limit. And I now have a good feel for how the options move over time relative to the underlying stock. My next foray into options will be documented here when I open the position.