Regular readers will probably remember our options expiration "max pain" theory. Basically, the idea is that upon option expiration, the maximum pain that investors can experience will indeed be the amount of pain experienced. In other words, if the market can close so that most options expire worthless, it will. So, by looking at where the majority of the open interest lies slightly before an expiration, you may be able to get a good feel for where things will end up by the time expiration gets here.

But wait a second. Didn't we just go through June's expiration? Aren't we past that point?

Well, no. We went through June's monthly option expiration. However, don't forget that the CBOE has started trading quarterly options on some instruments. The quarterly options expire at -- lo and behold -- the end of the last month of the quarter. As it just so happens, June is the last month of the quarter. So, we've got one more batch of open interest to think about before we forge ahead into Q3.

As usual, we'll be looking at the open interest for the NASDAQ 100 Trust, more commonly called the QQQQ's. They're highly traded and very liquid, and may best represent the majority of the market's participant's bets.

In any case, the table is below. The majority of the calls have a strike of 48.00, while the majority of the open interest on the put side of the table have strikes of 47.00. Theoretically the max pain would occur somewhere between there -- where both of those groups would expire worthless. That being said, we see a lot of 47.00 calls and a bunch of 46.00 puts. Though not the big centers of gravity, their open interest may tug a little bit too. So, based on the model, the QQQQ's "should" end the week somewhere slightly above 47.00.

Anyway, this is as much for fun as it is for strategic purposes. However, the growing open interest in these quarterlies is making this tool more and more meaningful. We'll continue to watch it and see if it has any merit. Just something to think about. The one caveat is that the open interest levels may change between now and Friday. So, you may want to follow it yourself between now and then.

QQQQ Quarterly Option Open Interest


Shall we continue going through some of the more important option trading strategies?

Bull Call Spread

OK - new chapter today. We already looked at a couple of ways to put money/income into your account. Today's spread strategy will create a net debit when you enter the trade, as most straight-out purchases of options do. However, a bull call spread will help you lower your cost basis (thus making your percentage return a little more potent). The downside? Yep, there is one. Lowering your cost basis also limits your upside potential. It may be worth it though.

First things first. The key component of a bull call spread is the purchase of a call. In that sense, this is a directional strategy - you want the underlying stock to move higher, well past your strike price. To get the maximum leverage for your trading dollar, let's try and buy a call that's at or near the money.

Let's use Caterpillar (CAT) as an example. If you were bullish on CAT shares and thought they were going to keep going higher - past their current price of 80.42 - you might purchase some November 85 calls at a price of 3.30 (or $330 per contract). The further past 85.00 Caterpillar share move, the more your calls are worth. If shares are priced at $100, then the 85 calls would be worth (about) $15.00 (or $1500 per contract). Relative to your $3.30 purchase price, that would mean a gain of 354%. Moreover, there's technically no cap to your potential gain.

If you wanted to make the same trade a bull call spread, you'd make the purchase exactly as described above. Then, you'd short a call with the same expiration month and an even higher strike than 85.00. Shorting that call would put some money back into your account. If you shorted the November 90 calls, you'd receive $1.80 (or $180 per contract) in cash.

Now, we know exactly what you're thinking. Why deliberately cap my potential gain by going short with a strike that's above my long strike price? You'll get no argument from us - that's exactly what you're doing.

The upside here is your original cost. An outright call purchase would cost you $330 per contract. A bull call spread would cost you $150 ($330 - the $180 you receive in sale proceeds). That cost basis is less than half of what it was. If shares move to $90, the intrinsic value of the long call would be $5.00 (or $500 per contract). With a net cost basis of $330 on the straight purchase, your gain is about 51%. With a net cost basis of $150 for the bull call spread, your gain is 233%.

But wait - aren't you still capping your potential? Yes. Whether CAT goes to $90 or $190, with a bull call spread your max gain is $350 per contract ($500 - $150). If the stock gets past $90, someone will exercise your short call (with a $90 strike) against you.

So why bother? The answer is, a bull call spread combines risk control with a reality check. In the above scenario, your risk was cut in less than half. Yeah, you did cap the upside potential, but was reaching a price above $90 actually realistic? Maybe it was, or maybe it wasn't. But if it wasn't, then using the bull call spread was a way to lower your risk (and entry capital) without necessarily capping your likely (not potential) gain.

In other words, a bull call spread can reign in your risk/reward profile by reducing both. Sometimes it hinders; other times it helps. But, bull call spreads are an easy way to play smart defense, even if it stifles the offense a little.

Price Headley is the founder and chief analyst of BigTrends.com.