Option Investor
Educational Article

Let's Be Crazy And Think Bull Market!

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By Lee Lowell

Eventually the stock market will continue its long-term uptrend. For those option traders who like to trade with the trend, they have witnessed a whole new ballgame. It's been a rough ride trying to handle the volatility and gyrations. The calls that you bought yesterday were looking good for a few hours but then the market collapsed. You sold out of your position only to see the market turn around and go back up. You take a chance and sell some put spreads (bullish), and then the market tanks again. You decide to buy back the short put spreads for a loss and of course the market then turns higher again. Losses on all sides. It's been happening to me recently. It's been a tough market to say the least! The days of just buying any old calls and watching the market go higher are over.

We've hit a phase in the market where it's so volatile, that you have to take your profits when they are there. Recently, that means you must be glued to the screen because the profits can happen at any time and then slip away. If you can't watch the computer all day, then you either stay out, or concentrate on long-term strategies. I've had multiple positions these past few weeks that I could've taken small profits on, but I got greedy. Some of them have now turned into small losers. Since I trade only option spreads, I know exactly what my maximum loss can be. The uptrend has not formed yet, so you have to trade the swings if you can.

Like my title says, let's be bullish and talk about some bullish strategies. (when the day comes) The first and easiest strategy to implement is the "long call." This is the position of choice for most novice traders and much of the general investing public. If you think the market is going up, you buy a call option. It's cheaper than buying the stock outright and the percentage return can be many times greater. Simple, right?

Not really. There are a few things to consider before parting with your hard-earned money. You must decide which expiration month and which strike price to choose. The "closer to expiration" options will be cheaper in dollar terms, but they also have less time to be correct. You have to have precise timing to make consistent profits with short-term options. Even if you don't choose a front-month option, you still must decide if you want to trade a three-month, six-month, nine-month, leap, etc. Only you can decide. Personally, I like to give myself at least six months worth of time. My timing has never been stellar, so I'd rather pay a little more to get that extra chance.

The next step is choosing which strike price to pick. An "out- of-the-money" (OTM) option will be the cheapest but it will have the least probability of profit. An "in-the-money" (ITM) option will be more expensive but it has a greater chance of being profitable. This is because it has a higher delta and it moves in tandem with the moves of the underlying stock. An OTM option is less responsive to moves of the underlying stock. An "at-the- money" (ATM) option has a strike price that is equal to the price of the underlying stock at that moment in time that you initiate the position. If the stock is trading at $100, then the ATM strike is the $100 call. An ATM option has a 50/50 chance of profiting.

And of course you must check the implied volatility (IV) levels of the options against its past levels. If you buy options when IV is high compared to previous levels, you are immediately put at a disadvantage. This is because you are buying an overpriced option. The options will eventually revert back to trading within their "normal" range and it will take the option premiums down with it no matter which way the stock moves. Even though the stock might move in your favor, your option position might not gain in value.

Another bullish strategy to implement is called a "call spread." It's a little more sophisticated as it entails two simultaneous transactions. A long call spread is achieved by buying a lower strike call option and selling a higher strike call option on a single ticket within the same expiration month. The price of the spread is the difference between the two individual option premiums. The strikes can be as far apart or as close together as you like. You can do a front-month spread or a leaps call spread. The long leg can be ITM and the short leg can be OTM, or both legs can be ITM or both can be OTM. The choices are great and it all depends on your risk tolerance and time frame.

My personal preference is to have the long leg ATM or slightly ITM and the short leg OTM. Again, my duration is about six months. The farther apart the strike prices, the more expensive the spread will be. But that also gives you a chance for a bigger profit. The spread will also cost more by having the long leg ITM and the short leg OTM, but the long leg will gain value faster because it will have a higher delta.

Just for example sake, here's what a bull call spread would look like. The stock is at $100. You could purchase a three-month $95/$125 call spread for 13 points. (hypothetical) The long leg is the $95 call which slightly ITM and costs $25 and the short leg is the $125 call which is OTM and costs $12. Since the spread is 30 points wide ($125-$95), and the total cost of the trade is 13 points, ($25-$12), the maximum gain could be 17 points. The maximum loss is always the amount that you paid for the spread. In this case it's 13 points. Your breakeven price is figured by taking the long leg and adding the cost to it. $95 + $13 = $108. This spread starts to become profitable once the underlying stock moves past $108. This is only 8 points away from where it is now ($100).

The pros of initiating a call spread versus an outright call purchase is the lower outlay of cash. A spread will always cost less than an outright purchase, if you are considering using the same strike. The $95 call by itself in the example above costs $25, whereas the whole spread only costs $13. Some see a spread as a hedge against a long call. Say you wanted to own the $95 call but craved a little insurance against it in case your market prediction was wrong. Here's where selling the $125 call comes into play. You now have 12 points of downside protection against your $95 call. Some traders will implement the short leg of the spread at a later time, but that is risky too because the market may tank before you get a chance to put on the short leg. That is not advisable unless you really know want you're doing. I always put on a spread with both legs at the same time on a single order ticket.

The only downside to using a call spread is that your profits are capped once the underlying stock has moved past your short leg. If our hypothetical stock starts trading at $130, we still can only make 17 points on the whole trade. If we purchased the $95 call outright, then we can participate in any major move that is made. It all comes down to how you feel about the market in terms of its magnitude and duration.

These are two of the most basic option strategies to use when participating in a bullish market. In this environment of whipsaw moves, it's best to pick expiration months as far out in time as possible. This will give you more margin for error in case the market isn't too cooperative. At this writing, those options would be for the January '03 expiration.

Good luck.

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