Most novice traders usually trade options in a simplistic way. They examine a stock, evaluate if it’s going to rise or decline, and then they buy a call or a put option to explore the opportunity, preferable an out-of-the-money one to maximize potential profit and minimize initial debits.
Unfortunately the prospects for a stock are not always straight bullish or bearish, meaning it rises or declines just moderately in short time periods, not enough to climb the huge mountain a trader needs for his out-of-the-money options to end worth something.
Experienced traders don’t like long odds.
They prefer a regular income stream delivering mild profits to long shots promising huge yields but hardly delivering anything. In this sense, most options strategies experienced traders use aren’t straight bullish or bearish as they prefer to exchange some of their profit potential for additional downside protection and easier to achieve breakeven points.
Today we will look into a simple case in which the trader is bullish about the prospects of a stock but acknowledges this potential as being limited, and thus exchanges unlimited profit potential (which he doesn’t think is likely to happen) for some extra downside protection, lower initial debit, and easier to achieve profit.
Instead of a naked call, the trader buys a bull call spread.
The trader buys an at- or near-the-money call option as he believes in a stocks’ upside potential but sells another call with the same maturity at a higher strike price.
Selling this second option, the trader reduces the premium paid and thus the cost of his bullish strategy. By doing this he also forgoes some of the upside potential and caps his profit.
If the stock rises to the strike of the shorted call, maximum profit is achieved, which is equal to the difference between the strikes minus the premium paid. Above that strike price, the extra gain he gets from his long call is cancelled by the loss deriving from the shorted call.
The idea is to estimate how much a trader thinks a stock may rise. Is it 5pc, maybe 10pc, or is it unlimited?
If you believe potential is unlimited because there’s some sort of announcement or decision that can cause a large price change, then go with the naked call. But, if you believe 5pc or 10pc are the most likely returns to achieve in your time interval, then buy a long call near-the-money and sell the out-of-the-money call near the higher limit of your estimated upside potential.
If the stock rises inside the interval of the chosen strikes, you will be better with the bull spread than you would with the long call. If instead the price rises above the higher strike, the naked call would deliver higher profit. But, don’t worry! You would still get a profit.
Let’s look at an example. This time we have chosen a Nasdaq 100 company – Fossil. A few weeks ago Fossil was trading at $120.50 and the following options were available for trading:
All options were expiring in 42 days. The option with strike at 120.00 will be our long call as it is near-the-money (it is always tough to get something really at-the-money).
Regarding the shorted call, there’s a fair amount of options available. Recall what we said above. First, estimate how much you think the stock will rise and then, choose an option with strikes near the upper limit of the interval. Let’s say you think Fossil can rise 10pc – 12pc at most. Then the call with strike at 135.00 would be a great choice here.
So, now that we have chosen both the long and the short call, we just need to add them together to build our strategy. You will buy the 120 call at $5.10 and short the 135 call to receive $0.70. The total debit resulting from this strategy is equal to $4.40. Your initial debit is then reduced from $5.10 to $4.40 when comparing with a naked call strategy.
If you opted for the 130 call, the reduction would have been higher. The maximum loss you can incur is equal to the initial debit while the maximum profit is equal to $6.40.
The following table shows a comparison between the naked call and two bull call spreads.
There’s no doubt the naked call offers the higher upside potential, but also increases the breakeven bar and maximum loss. The following chart helps understand these key points.
You can see that the naked call underperforms the bull spreads up to moderate stock rises. Only in very unlikely situations of sudden price increases, the extra cost of the naked call is worth it.
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