With the Dow and S&P 500 falling just off their all-time highs recently and yet refusing to move much lower at this point, it probably makes sense to keep at least a few bullish trade ideas in your trading stable. The market is due for some type of bigger correction, but who knows when that will happen. Even if it does pullback sooner than later, there will be another bullish opportunity at some point rest assured. Traders often ask me is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a few option strategies that can accomplish this goal. One that may be a better option compared to the rest is a debit call spread which is sometimes referred to as a bull call spread.
When implementing a bull call spread, an option trader purchases a call option at one strike and sells the same number of calls on the same stock at a higher strike with the same expiration date. Here is a trade idea we looked at in Group Coaching just about a month ago. In late August, Tesla Motors (TSLA) moved up to a resistance area right around $260, formed a bullish base and then closed above resistance at around $263. With implied volatility (IV) generally being low at the time, which is advantageous for purchasing options as with a bull call spread, and a directional bias, a bull call spread was considered.
The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that at the time one September 265 call was purchased for 8.00 and one September 270 call was sold for 6.00 resulting in a net debit of $2 (8 – 6). The difference in the strike prices is $5 (270 – 265). He would subtract $2 from $5 to end up with a maximum profit of $3 per contract. So if he traded 10 contracts, he could make $3,000 (10 X 300).
Although he limited his upside, the trader also limited the downside to the net debit of $2 per contract. To simply breakeven, the stock would have to trade at $267 (the strike price of the purchased call (265) plus the net debit ($2)) at expiration.
Advantage Versus Purchasing a Call
When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the out-of-the-money September 265 call, he would have paid $8. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.
By implementing a bull call spread, traders can hedge their bets; limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.
With the market once again considering a move higher as earnings wind down, it might be a good time to talk about call options. When an option trader buys a call option, he or she has the right to buy the underlying at a particular price (strike price) before a certain time (expiration). Keep in mind that just because the option trader has the right to buy the stock, doesn’t mean that he or she has to necessarily do so. The call option just like a put option can be sold anytime up until expiration for a profit or loss.
A lot of traders especially those who are just learning to trade options can fall in love with call options and especially short-term call options because they are cheaper than call options with longer expirations. We can classify short-term call options as call options that expire in less than thirty days for the sake of this discussion. But there is a potential problem with purchasing short-term call options. The shorter the amount of time that is purchased, the higher the option theta (time decay) will be. The higher the time decay, the quicker the premium will erode away the call option’s premium. The call option may be cheaper due to a shorter time until expiration, but it may not be worth it overall. Let us take a look.
With Tesla Motors (TSLA) trading around $260 last week, an option trader might have considered call options to profit from an expected move higher. He could have purchased the August 260 calls for 3.30 that expired in 3 days. Yes, the options are cheap and yes they will profit if TSLA moves up vigorously in the next couple of days. But the option theta is 0.70 on the call options meaning they will lose $0.70 for everyday that passes with all other variables being held constant, In fact if the stock trades sideways, the option theta will increase the closer it gets to expiration since there is currently no intrinsic value (the in-the-money portion of the option’s premium) on the call options.
If an option trader purchased the September 260 calls for TSLA, it would have cost him 12.00 and it would have made the at-expiration breakeven point of the trade $272 (260 + 12) versus only $263.30 (263 + 3.30) with the August call options. But the major benefit to buying further out is option theta. The September 260 calls had an option theta of 0.15 meaning for every day that passes, the option premium would decrease $0.15 based on the option theta and all other variables being held constant. This is certainly a smaller percentage of a loss based on option theta for the September options (1.25%) versus the August options (21.21%) especially if the stock trades sideways or moves very little.
Fast forward to August expiration, TSLA closed basically at $262. The August 260 call would have expired with an intrinsic value of $2 (262 – 260). If the option trader did nothing up until expiration, the long August 260 call would have lost $1.30 (3.30 – 2) because there would be no time value (option theta) left and only the intrinsic value. The September 260 call would have lost approximately $0.45 (3 X 0.15) in theta but also gained $1 (2 X 0.50) from delta based on a delta of 0.50 and a $2 (262 – 260) move higher. The September 260 calls would now be worth $12.55 (12 + 0.55) and profited $0.55 (12.55 – 12).
Having enough time until expiration is a critical element when an option trader is considering buying options like the call options we talked about above. Keep in mind that as a general rule, options lose value over time and the option theta starts to accelerate even more with 30 days or less left until expiration. Buying a call option with more time until expiration will certainly cost more than one with less time but the benefits, including having a smaller option theta, might be worth the more expensive price especially if the underlying fails to move higher.
With earnings season in full gear and major players like Priceline.com and Tesla ready to announce soon, it is probably a good time to review how option prices are influenced.
Perhaps the most easily understood of the options price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.
The price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.
The third price influence is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we are in the midst of earnings season, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium. The value of implied volatility is generally inversely correlated to price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price (e.g. earnings, FDA decisions, etc.).
New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these options pricing influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over an earnings announcement.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. No statement on this site is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.