by Josip Causic | November 20, 2009 6:42 am
This article originally appeared on The Options Insider Web site.
This is my third installment of my five-part series on vertical spreads. If you missed my earlier articles, you can check them out below:
See Part I: Vertical Spreads 101
See Part II: Bear Call Spreads
In this article, I will introduce you to a vertical debit call spread trade, or bull call.
A bull call involves looking at three things:
3. Implied Volatility (IV)
I love doing verticals on the major U.S. indices or exchange-traded funds (ETFs), because this reduces the steps involved from three to two: technicals and IV. With certainty, one can claim that those underliers will never get delisted. Hence, fundamental analysis is reduced to economic announcements.
A bull call spread is a strategy that could also be used when market conditions are:
1. Somewhat neutral to bullish; and
2. The implied volatility of the underlying is low or in its lower range.
Buying a vertical debit spread is much more suitable for the environment that we are currently in than selling a vertical credit spread as described in the previous article.
Once a suitable underlying is selected, locate on the call side of the option chain a call that is two steps in the money (ITM) and another call that is above it.
For instance, if the issue is sitting at $496.18, then buying a 490 call and selling a 495 call would make sense; the long option should be purchased at the ask and the short one at the bid.
The visual depiction in the chart below illustrates my point:
The issue is trading at $496.18, and after buying the 490 call is done, the selling of the 495 call takes place. On many platforms, the two transactions can be performed simultaneously, as it is shown below.
See full-size image.
This highlights not only the strike prices involved but also the Greeks of the spread. The aggregate of the two options’ deltas (sold call and bought call) produce a positively correlated delta.
Whenever the delta is positive, the position’s outlook is bullish by nature. In our example below, the purchased 490 call has a positive delta of 0.6788, while the shorted 495 call has a negative delta of 0.4738.
The aggregate of the two deltas (0.6788 – 0.4738) is positive 0.205, and when it gets multiplied by the number of contracts (10 in our case), it becomes 2.05 (keep in mind that each contract controls 100 shares).
Therefore, 2.05 times 100 gives us $205, which is displayed on the Spread Pane portion of TradeStation under the Position Delta. What that number means is that for every single dollar that the underlying moves up, the position will make $205.
The figure below shows the max cost of $3,600, which comes from buying 10 495 calls at $7.40 and selling 10 490 calls at $3.80 ($7.40 – $3.80 = $3.60 or $360 a contract) and then multiplying that $360 by 10 contracts. The maximum loss or max cost is $3,600 while the max profit is $1,400. This number comes from the width of the spread (495 call – 490 call equals five points) and the subtraction of the max cost ($5 – $3.60).
To figure out the ROI (return on investment) the profit needs to be divided by the maximum cost. In other words, the maximum reward of $1,400 divided by $3,600 equals 38%.
Once the 490/495 debit call spread is placed, daily monitoring needs to be done, for this vertical spread does require follow-up action. It is this follow-up action that will produce additional commission.
In my previous articles on the vertical credit spread, it was possible to have both options, sold and bought, expire worthless. In this case, if the trader lets both options expire worthless, then the trader achieves the maximum loss of $3,600.
See full-size image.
The figure above shows the profit and loss of the bull call. There are two axes on the chart. The horizontal one displays the strike prices. In our case, the two call strike prices aren’t marked on the chart, for our bought 490 call is in between 488 and 492. It is those two numbers (488 and 492) that are shown on the chart. Also, our sold 495 is in between 492 and 496.
The vertical axis shows the options profit and loss. Everything above the horizontal line is profit up to $1,400 and anything below the horizontal line up to $3,600 is a loss. Those numbers also aren’t clearly marked on the TradeStation profit and loss chart. Again, the numbers displayed on the vertical line are only listed in the thousands and not in the hundreds.
Go on to bull put spreads.
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