Bull Call Spread – Understanding Options for a Bull & Bear Market Part 3

Bull Call Spread – Understanding Options for a Bull & Bear Market Part 3

 

Bull Call Spread – Understanding Options for a Bull & Bear Market (Part 3)

 

Now let’s take it to the next level and walk through adding one piece. We did the out rights. Now, let’s do the verticals which are going to be again, both bullish and bearish. We will start with the bullish side and then make some pricing comparisons and risk profile comparisons between these strategies as we walk through. First, we’ll do the bullish outlook side.

Bull call spread, stocks at $90. Got a month to go till expiration, a bull call spread involves buying a lower strike call, in this case $90, and selling the higher strike call. In this case, $95 we do that for a cost of $1.35. Now the best thing that can happen here is the stock rallies through $95. We own the right to purchase shares at $90. We are obligated to sell shares at $95. We can capture that five-dollar difference, and that’s the best that we can get. So, if we can capture that $5, and we paid a dollar thirty-five up front for it.

You can see the maximum gain potential here is $3.65. The maximum risk is what we paid up front. All these options can only go to zero can’t get any worse than that. So, risk $1.35. Margin in these cases for verticals really is the capital requirement that you’re required to have up front and it is very straightforward. In this this case a dollar thirty-five. We just have to pay for what we bought and break even. The stock price at expiration, that would pay us back the upfront cost. So, if the $90 call option that we own is in the money by $1.35 at expiration, then we have reached our break-even level. Let’s look at a profit and loss graph on this and then break it down a little bit.

You see above $95 we reach our maximum gain and it levels off up there. We are obligated to sell the shares that we own the right to buy and we can’t make any more money up top. Down below, below $90, the options expire worthless. So, we realize our max loss of a dollar $35 and in between our profit and loss depends on where the stock sits in relation to $90, $1.35. If it’s in between the strikes, we have a decision to make. If we’re at expiration the stocks sitting around $91, $92, we have to decide do we exit the position sell the $90 call for what we can and take a realized profit or loss off of that or do we change our minds and buy the shares?

With the stock in between strikes we’ll see this again in the further examples I walk through. When the stock is in between strikes you are exposed to a potential stock position and there’s a difference in mindset for most investors depending on whether or not that resulting stock position would be long shares or short. Drastic difference between those two. In this case the potential to buy shares might be something you’d be interested in considering if not, remember we were bullish and we didn’t want to buy shares to begin with if not close the trade out and move on to the next trade.

One more thing to mention, this is strike selection on the short side. Generally speaking, and this trade strategy is one of the examples, you’re selecting a strike that you believe the stock will not rally through too far. So, in this case, we’re not concerned about giving up profits at $96, $98 or $100 , because we I think the stocks going that high. So, to reduce our cost and reduce our risk, we sell the $95 strike because we’re not too concerned about giving up those gains up above that level. In addition to that, the analysis is going to incorporate what can I actually get for the $95 strike? In this case, 70 cents.

That’s a reasonable amount of premium, it lowers our cost by a notable amount. But, if the $95 call was only trading for 25 cents you might just decide it’s not worth it to sell an option for that amount of money for the obligation that it provides or forces upon me. It’s not worth selling an option for that price and getting the slight reduction in cost. So, if that’s the case then maybe you’re back to looking at buying a call. Or if you’re intent on doing a spread, you may shift your strikes around a little bit. You may have to lower the $95 strike and look at selling a $93 or $94 strike. And that changes your potential for gain but lowers your cost at a magnitude that you’re more comfortable with. So, it’s a little bit on strike selection in the bull call spread, buying the lower strike call and selling the higher strike. Remember that buying low strikes, selling high strike, and we’re going to see that again here with the bull put spread.

The second vertical that is bullish two sides to the trade. We’re selling a $115 put for $2.00 and buying a $110 put for 70 cents. The net credit here is $1.30 and I want receiving premium. This is a credit spread. So, the maximum gain is just going to be what we receive upfront the value of these options can’t go any lower than zero. So, $130.00 is our potential gain. Worst case situation is if the stock sells off and goes down under $110, we’re obligated to buy shares at $115 because we own the right to sell those shares out at $110 that would be a loss or giving back five dollars to the market.

We received a dollar thirty up front and that’s where $370 comes from. That would be a net loss of $370 giving back five after having received $1.30 upfront. Margin requirement, capital requirement is the maximum risk could be higher but that’s right where it should be and breakeven is when the higher strike that we sold is in the money by the exact amount of premium we received upfront the $1.30. That means we’d be purchasing shares at $1.15, and we would now see share sitting at $113.70. That’s a that’s a dollar thirty loss and that would equate what we received up front. On the p&l graph we’ll walk through this and then and then make some interesting comparisons. Above $115, that’s our sweet spot. Everything expires worthless and we keep our max profit. Under $110 max loss and in between the two our break-even point of $113.70. Now, on this side and we’ll contrast this when we walk through the credit spread on the call side. If the stock is in between the strikes, remember when I said earlier ones in between the strikes and the potential resulting position is long stock.

It’s very different. From an Investor’s perspective than the resulting position being short stock, and this case we might decide that owning shares at $113 with a break-even point one $113.70is reasonable. So, with the stock in between those two strikes the $110 isn’t worth anything to us, but we might go ahead and change our perspective. Maybe we’re more bullish now that the stock has drifted down to that level and we’re comfortable buying share. So, you want to keep that in mind as you manage the position.

I do want to compare these two. The bull call spread that we bought in the bull put spread that we sold. So, I’m going to toggle back. First of all, look at the shape of the graph here how we have a flat line up top. The numbers are going to be different on the scale. But, we flat line up top and down below we flatline our loss and in between we have this profit and loss depending on where the stocks sits in between the two. If I go back to the call it looks exactly the same; at the high strike that we, in this case sold, here is the flat line profit at the lower strike which we bought. You have a flat line and in between you have profit and loss. We bought the low strike and sold the higher strike. And here the same thing, we bought the lower strike and sold the higher strike. So, these trades are the same thing, buying a call spread and selling a put spread has the same risk profile and it works the same way from a risk perspective. It’s interesting to understand and to notice that relationship between options and I’ll tack on some different numbers just to emphasize that. If you’re looking at a five-point wide call spread, let’s say it’s $75 strike and $80 strike and you can buy that call spread for $3.

Think about what that means, you’re risking three dollars if the stock drops and if the stock rallies and you can achieve your full value of $5 from it you make two so you pay three and you risk three to make two if the stock stays above the strikes. Think about what the put spread might be saying, strike $75.80. If we can sell that put spread for two dollars and the stock stays above both strikes and they expire worthless, we make two dollars. And if the stock drops below the lower strike we give back five dollars, a full value, and we lose three. So, risk three to make two. It’s the same risk profile between the two trades and they are synthetics of each other. The differences are in the potential for variances in execution prices and what may happen with respect to position management needing to close out the trade or having exercised an assignment activity.

Most of the trading that you’ll see will occur in the out of the money options because usually the lower priced options, that have lower Delta’s have more high quality or I should say tighter bid-ask spreads. So, execution prices on the lower priced options tend to be a bit better. So, you’ll see those trade more frequently, but it is interesting to note the similarities between the two. If anyone ever said they were interested in buying an in the money call spread for three dollars. The first thing that would come to my mind is, why wouldn’t you sell the put spread? What price can you get the put spread for and sell it? Because that might be a better execution price. Also, if the stock stayed higher you wouldn’t have to deal with any exercise or assignment activity by selling a put spread versus buying a call spread. Just interesting comparison between the two and those are the verticals on the put side.