Pay Less Than Buffett for MasterCard

05/19/2011 7:00 am EST

Focus: OPTIONS

An option spread strategy can allow traders exposure to the market’s best stocks but with limited risk and at just a fraction of the cost it would take to purchase pricey shares. Here’s a fine example.

Despite the recent weakness in the equities market, credit card companies have yet to see the bears come home to roost. The likes of American Express (AXP), Visa (V), Discover Financial Services (DFS), and MasterCard (MA) have held up very well.

The relative strength shown by this industry may signal that they are poised to continue marching higher once the selling pressure in the broader market abates. Market maven Warren Buffett is also placing a vote of confidence in the credit card space, as evidenced by his 216,000-share purchase of MasterCard, which was revealed in Berkshire Hathaway’s (BRK.A) recent 13F filing.

Many option traders and investors may become discouraged at the high price tag for stocks like MA, which is trading close to $300. But such discouragement is unnecessary if investors take the time to learn how to use option spreads.

The bull call spread is one strategy that allows traders to gain exposure to further upside in MA while keeping cost to a minimum. It involves buying a lower-strike call option while selling a higher-strike call option in the same expiration month. 

The maximum potential risk is limited to the net debit paid at trade inception. The maximum potential reward is limited to the distance between the strike prices less the net debit.

First, here’s a daily chart of MA:

chart
Click to Enlarge

Bullish traders with a shorter time horizon may consider purchasing a MA July 285-295 call spread for around $3.80. That is, buy to open the MA July 285 call while selling to open the MA July 295 call. If entered at $3.80, the max risk is limited to $3.80, while the max reward is $6.20.

Bullish traders with a longer time horizon may consider purchasing a MA October 285-305 call spread for around $7.90 (at the time of this writing). That is, buy to open the MA Oct 285 call while selling to open the MA Oct 305 call. If entered at $7.90, the max risk is limited to $7.90, while the max reward is $12.10.

Due to MasterCard’s options having a little wider bid-ask spread than I would prefer, make sure to use limit orders when entering to try to attain the best fill possible. In timing the entry, I suggest waiting until MA clears the high of the recent two-week consolidation around $283.

By Tyler Craig of TylersTrading.com

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