An Option Strategy to Put the Odds on Your Side

  • SumoMe

OK this one is targeted primarily to option traders, but can also be useful to traders who might consider trading options or to traders who are looking for a potential way to improve their investment odds.

So let’s consider

A) A potentally  bullish scenario

B) The standard way to play it

C) An alternative way to play it

In Figure 1 we see ticker CSCO as of 3/17/15:

A) In an uptrend (above its 200-day moving average)

B) Bouncing off of an oversold reading (my RSI Everything indicator fell to -32 then reversed)1Figure 1 – A potentially bullish setup for ticker CSCO on 3/17 (Courtesy: AIQ TradingExpert)

So for argument’s sake let’s refer to this as a “bullish scenario.”  In other words, we will hope that the uptrend will reassert itself and look for a way to make money if it does, while simultaneously limiting our risk by using an options strategy.

The “standard” approach would be to buy call options which stand to gain if the price of the stock goes up.  For our example trade we will buy 15 CSCO May 2 call options at $0.60 per contract.  The particulars appear in Figure 2 and the risk curves for this position appear in Figure 3.2Figure 2 – CSCO Long May Call Details (Courtesty OptionsAnalysis.com)

3Figure 3 – CSCO Long May Call Risk Curves (Courtesty OptionsAnalysis.com)

*The cost and maximum risk is $900

*With the stock trading at $28.15, the breakeven price is $29.60

*There are 59 calendar days left until option expiration

An Alternative Approach: The Directional Calendar Spread

Now let’s consider an alternative.  This strategy is typically referred to as a “Directional Calendar Spread”.  Here’s how I arrived at this trade:

At www.OptionsAnalysis.com I went to “Options/Skewfinder” and created and save a “Wizard” (a group of settings that can be reused in the future) with the settings that appear in Figure 4.4Figure 4 – SkewFinder inputs for www.OptionsAnalysis.com

From the output screen I took the top ranked trade which involves buying the July 29 call and selling the May 29 call EXCEPT:

*Instead of trading this position in a 1 x 1 ratio

*We will trade it in a ratio of 3 x 2 (this creates a position that has limited risk on the downside and unlimited profit potential on the upside – See Figure 6)

To compare apples to apples we will buy 18 July 29 calls and sell 12 May 29 calls so that the trade costs exactly the same as the long call trade – $900.

The particulars and the risk curves for this trade appear in Figure 5 and 6.5Figure 5 – CSCO directional calendar spread details (Courtesty OptionsAnalysis.com)6 Figure 6 – CSCO directional calendar spread risk curves (Courtesty OptionsAnalysis.com)

There are many similarities and differences between these two trades but there are 4 key things to focus on:

1) The long call position does enjoy greater maximum profit potential as it has a higher “delta” (556 versus 279 for the calendar spread.  This means that for each dollar the stock rises in price the first trade will gain $556 and the second $279).  So if a trader is flat out bullish and desiring to maximize his or her gains this trade will clearly make more money if that outlook proves to be correct.

2) The directional calendar spread stands to benefit from time decay – i.e., the fact that option time premiums decline to zero by expiration – while the long call stand as to be hurt by time decay.  We can tell this by the fact that the long call has a “Theta” value of -$11.12 (meaning it will lose $11.12 of time value each day) while the directional calendar spread has a positive “Theta” value of +$0.28).

3) At May expiration the long call position will cease to exist as the May 29 call will expire.  At May expiration the calendar spread will still hold 9 long July calls, which opens up other profit opportunities (for example, selling June calls and creating another spread position).

4) The directional calendar position has a breakeven price at the time of May option expiration of (approximately) $27.95 (I say “approximately” because a rise in implied volatility for the July call prior to May expiration could result in a higher breakeven price and vice versa).  The long call position has a breakeven price of $29.60, almost $2 higher than the calendar spread.

In other words, if CSCO stock is below $29.60 prior to May expiration the position will show a loss (assuming of course that is held until expiration) the directional calendar spread could conceivably be showing a profit if CSCO is under at $27.95 a share at May expiration.

The trade off to consider is this:

1) The long call position has the greater profit potential.

2) The directional calendar spread has the greater probability of generating a profit.

Now let’s fast forward to the close on 5/4/15.  The price of the stock has risen from $28.15 to $29.17.  At this point, one can argue that the Long May call position was the better trade.  The stock rose 3.6% in price which caused the option to rise 41.7%.  A trader could sell this position right now and reap his or her reward.  And taking a profit might just be an excellent idea at this point for the following reason:

*With 11 days left until expiration the stock is currently trading below the breakeven price of $29.60.  So if his position is held another 11 days and the stock does not rise from the current price of $29.17 to $29.60 or above, then the current open profit of $375 will vanish and the trade end up showing a loss.7Figure 7 – CSCO Long May Call with 11 days left until expiration (and a lot hanging in the balance) (Courtesty OptionsAnalysis.com)

Now let’s look at the current status and future prospects for the directional calendar spread.  As of 5/4/15 this trade is also showing a profit but the only $186, or +20.7%. So again, it can be argued that the May long call has been the better trade.  But before declaring a winner let’s look at the future prospects for the directional calendar spread.

As you can see in Figure 8, time decay could help this directional calendar trade a lot as May expiration nears.  In fact, the holder of this position would be perfectly content to see CSCO remain relatively unchanged between now and May expiration as the position profit could soar. 8Figure 8 – CSCO directional calendar spread as of 5/4 (Courtesty OptionsAnalysis.com)

Also, remember that when May option expiration hits, the holder of this position can either ext the entire position by selling the July calls and either buying back the May calls or letting them expire worthless depending on whether the price of CSCO is above or below the $29 strike price.

Summary

OK, so hat’s a lot to “chew on”, especially if your knowledge of options is limited (in fact if your knowledge of options is limited, let me say “Thank You” for slugging it all the way out to the end.  So let’s approach this from two angles:

If you are an “options person” (and I think you know who you are):

Whether or not you ever employ the Directional Calender Spread strategy is not the primary point.  The primary point is to always remember that there is usually more than one way to play any give situation.  In this example buying the call option would have worked out fine and you could cash out 11 days prior to expiration and taken a nice profit and avoid any concerns about giving it back due to time decay.

Still the directional calendar spread still has alot of upside potential in the days ahead as time decay may serve to “boost” profits if CSCO does anything other than fall sharply.  The holder of this position also has the opportunity to generate additional gains with the July call option portion of this trade.

If you are “new to options”:

Hopefully this piece opened your eyes to the possibilities available for traders who know how to do more than just buy shares of stock.  Or of course, your just confused as hell.  Here’s hoping it’s the former.

Jay Kaeppel

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