The Financial Select Sector SPDR Fund () ETF just broke out to a 10-month high ahead of the conclusion of the Federal Reserve two-day meeting Wednesday. While it may have been best to wait for the outcome of the meeting, investors who think XLF today will continue to rally and don't want to risk significant capital can use long call options.
Shares in the exchange traded fund are trying to clear stubborn resistance near 36. XLF today continues to shape a saucer-style pattern.
So, rather than buy the stock outright, buying the call option in XLF may serve as a a good way to benefit in the upside gains while limiting the downside risk.
A call option is a contract between a buyer and seller. The contract gives the buyer the right to purchase a certain stock at a certain price, known as the strike price, up until a certain expiration date.
One of the benefits of call options is that they provide leverage. That is, this can be both a good and a bad thing.
XLF Today: Setting Up The Trade
Assuming an investor wanted to buy 100 shares of XLF today, he or she would have to invest around $3,650 at the current price.
Instead, the investor could gain a similar exposure using a fraction of the capital by buying a call option. One call option gives the investor exposure to 100 shares.
Buying one XLF call option with a 36 strike price and expiring June 16 would only require around $225 in capital rather than $3,650.
The 36 call option has a delta of 61, meaning it is roughly equivalent to owning 61 shares of XLF. However, that exposure will change over time as the ETF moves.
The break-even price for this call option? Take the strike price plus the premium paid, which would make the break-even price 38.25.
The most the trade can lose: the premium paid of $225. That would occur if XLF finished below 36 on June 16. However, if XLF stock shoots higher, the upside is unlimited.
Using options in this way can be a great way to gain exposure to a stock without risking as much capital as would be required to buy the stock outright.
Risk Control
Savvy traders can further reduce the risk by selling an out-of-the-money call, turning the trade into a bull call spread. For example, selling the June 16, 40 call would reduce the trade cost by around $40 but would also limit the upside above a stock price of 40.
A stop loss could be set if XLF drops 8% from the entry point or if the value of the option trade drops by 40%.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
