I was reminded the other day that our subscribers comprise options traders of all skill levels, from newbies to traders who have been trading options for decades. Today we're looking at a basic concept that might be suitable review for experienced traders and valuable information for newbies.
Suppose you believe that your preferred trading vehicle's price has reached a critical level and is likely to change course. You want to place a bet on that move. Should you buy a long call or put or employ some kind of spread? Let's use Ford (F) for our study. Remember that these articles are roughed out ahead of time and so these charts are not up to date. That also means we can take a second look at the conclusions laid out in the articles.
Daily Chart of F as of 3/29/2012:
Since the beginning of February, F has been coiling inside a neutral formation. Declining volume doesn't give us many clues as to the next direction. RSI has broken through its coil to head down, but it's already reached levels from which it sometimes reverses and moves higher. However, markets had been down over the last few days when this chart was snapped on March 29, 2012, and F didn't break through to the downside, so you decide $12.00 seems like fairly strong support. This is of course a hypothetical situation. I decided no such thing and did not open a trade in F on this date.
What are your choices? F is fairly cheap as stock goes, so you could decide to buy 100 shares of F at $12.34, incurring costs of $1,234.00 plus commissions. What is your risk? It's $1,234.00 plus commissions. While it's unlikely that F's stock will go to zero over the course of the two weeks or so you plan to be in the trade, it's not an impossible occurrence. It's certainly not impossible that if a severe market shakeup occurred, F could lose the support at $12.00 and drop to $10.00 by April 10. You would have lost $234.00 if that happened.
What are the benefits of just buying the stock? The delta on this position is 100, which means that for every point (dollar) F rises, you make $100.00. There's no decay. Let's set a test price and a test point by which to compare this to other possible trades. Let's say that F rises to $13.50 by that same April 10 date. You would have gained $116.00 minus commissions.
What if you'd bought a call? And which strike would you choose, if you wanted to do that? When I was buying a call for a move I thought would occur over a week to two weeks, I often chose a call that had a delta of about 70 (0.70 without the multiplier) or above. I didn't want it to be too far out of the money or it wouldn't benefit at all from a slow movement up over a period of 10 days or so. On that afternoon, that would have meant buying an APR12 12 or 11 strike call, with deltas of 67 and 90, respectively. Let's try the 11, put it on a profit-and-loss chart and roll the date forward to April 10.
With a cost of $1.25 in commissions, this purchase would theoretically have cost you $142.50 on March 29, and that would be your total risk in the trade.
OptionsOracle Chart of an APR12 11 Strike Call:
You can see the rolled-forward date in the blue slot on the top right header on this chart. You can also see that the trade would be profitable. Sizing requirements do not allow me to show the theoretical profit calculated by OptionsOracle, but it was estimated at $109.30, including the commissions paid. This is less than the $116.00 that you would have made if you'd bought the stock. It's less by the theta- or time-related decay that would have occurred.
Normally, in a rising market, I would suggest that someone using a theoretical chart such as this one should lower the implied volatilities, as this charting program allows you to do, since implied volatilities tend to decline in a rising market. Doing so would have lowered the value of the call and lessened the theoretical profit. However, implied volatilities have been low and may not sink much lower. In addition, when prices first break out of a months-long formation, sometimes the implied volatilities go up, not down, even when the underlying is climbing.
What if F dropped to $10.00 on April 10, as we imagined when we were discussing buying stock? Fairly estimating the price of an option after strong support is broken and the underlying's price drops requires increasing the implied volatilities. Although the sizing requirements hid the button for doing so, it's easy to accomplish this on the PnL chart provided by OptionsOracle. The calculation shows a theoretical loss of $141.88. That's less than you would have lost if you'd owned the stock. Why is that? That has to do the way delta changes as the option moves from in-the-money to at-the-money to out-of-the-money. The out-of-the-money option will have a lower delta than the in-the-money one, and so will be less impacted by the drop in price.
Apr12 11 Strike Call if F Drops to $10.00:
What would happen if we constructed a spread trade? Let's try 11/13 debit call spread, constructed by buying an Apr12 11 strike and selling an Apr12 13 strike call.
Employing a call spread requires paying two commissions, one of the drawbacks of the spread versus the single call. Another drawback is that gains are capped. The most it's possible to make on this trade at expiration is the distance between the two strikes (2 points) x $100 multiplier - the cost of the trade: 2 x $100 - $136.50 = $63.50. Another risk relates to the fact that F is a dividend-paying stock and you've sold a call as part of this trade. You don't want to let that sold call get too deep in the money near expiration or ex-dividend day, when there's little extrinsic value left in that sold call. Someone could exercise their right to buy the stock from you at the $13.00 strike and you would owe them stock. If they did that on ex-dividend day, you would also owe them dividends.
If the potential gain is fixed, so is the potential loss, one of the benefits of choosing a spread. That potential loss is $136.50 as long as you're careful around ex-dividend day and don't also end up owing someone dividends. Another advantage to the spread trade relates to the implied volatilities. You don't have to worry so much about value leaking out of your long call if volatilities go down because they're leaking out of the other call, too. Having a spread somewhat insures you against volatility changes, and insures you, too, against accidentally buying an expensive option. Most likely, if you've bought one that was expensive due to plumped-up implied volatilities, you've sold an expensive one, too. That's a simplistic view because options at different strikes can react differently to changes in implied volatility. However, traders sometimes buy single calls or puts when implied volatilities are low and switch to spreads when they're high and likely to drop, making single options expensive to buy.
What happens to the spread if F is at $13.50 on April 10, our comparison value and date?
Spread Profit-and-Loss Graph on April 10:
OptionsOracle estimates the profit at only $56.66, less than would have been made with a single long call. However, that's still over 40 percent of the amount at risk. It's also close to the most money that it would be possible to make if F were to be at or above $13.50 at APR expiration. If I'd been in such a trade, I would think it a good idea to close out the trade and take the profit, not waiting into expiration for a few paltry more dollars.
What if F dropped to $10.00 by the same date? A glance at the chart above will tell that story without showing another chart. By $10.00, the loss line has pretty well flattened at the maximum possible loss. Theoretically, the loss is $135.76, just a touch under the maximum loss.
Obviously, as I edit this article on April 6, 2012, with markets not due to open again until April 9, F has neither climbed to $13.50, nor dropped to $10.00. How would a trader have treated the trade Thursday afternoon, ahead of a long weekend, especially with Non-Farm Payrolls due on Friday, when markets were closed? That would depend on the trader's goals. I likely would have closed any bullish trade and taken either my lumps or my gains, whatever they might have been. Some traders might have considered rolling the trade forward since F still hadn't broken through that $12.00 support, but I personally would have wanted to have seen what the Non-Farm Payrolls looked like and how equities reacted before I rolled into a new trade. However, this article's appearance this weekend will allow interested subscribers to compare the performance of the various strategies on April 10, if they want to do so.
This is a far from comprehensive study of long stock versus long call versus long call spread. In order to do that, we'd have to compare deep-in-the-money, in-the-money, at-the-money, and out-of-the-money single calls and call spreads to the long stock purchase and each other. What this does show, however, is that if you want to go beyond single call or put buying as your option strategy, you can compare various tactics on the same underlying by putting them on a chart such as this and rolling the date forward, playing around with the implied volatilities and thinking about risks and rewards. This article didn't even address another way to employ a spread to create a bullish trade: selling a put credit spread. Length requirements just don't allow an exhaustive study in each article, so that's fodder for a future article.
However, this article includes lots of fodder for thinking about your trades. Happy Experimenting, Newbies and Others!