I was talking with a student the other day about buying calls. He asked me to go through an example of buying a call on a technical-value play. I decided to reference the chart of 3M Co. (NYSE: MMM). I knew that it was in a longer-term uptrend but has been experiencing a pullback, offering the opportunity to get into a longer-term trend at a decent level. I expected to walk through buying an in-the-money call to play this opportunity. I figured we’d buy the MMM June 90 Calls with the stock trading around 93.56.
But as we were looking at the options trading opportunities available in the chain, I pointed out that we need to look for alternatives to the trade, and not just take the first strategy that comes to mind. So we looked at an at-the-money call and an out-of-the-money call. We decided against them as MMM would need to move too much to make the trade work out. And, after all, we were only anticipating a modest move.
Modest moves over time are often best played by a call spread. In our analysis, I pointed out that the bull call spread ended up being a superior way to play the trade — better than buying the in-the-money call outright.
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We started thinking about which strikes were best to use and came up with some alternatives. Then my student reflected that a bull call spread is the same as a bull put spread, synthetically, and asked if we should consider selling a put spread instead. So we looked at put spreads. In the spirit of making a more conservative play, we selected lower, out-of-the-money strikes to provide more margin for error. The trade we ended up deciding would be the best choice of all available options wasn’t an in-the-money long call; it was an out-of-the-money short put spread. Specifically selling the MMM Jun 87.5 – MMM June 90 Put Spread at 0.25 or better. That is, sell the MMM Jun 90 Puts and buy the MMM Jun 87.5 Puts.
And so the lesson of the day was not on how to buy a call at all; it was on selecting the best strategy for a given outlook. Traders must always entertain at least three alternatives for every opportunity. This is the thought process I go through on every single trade: consider all the possibilities and select the best one that offers the best risk-reward ratio, the best pay-out structure, and the best chances of success.
Dan Passarelli of MarketTaker.com writes the Market Taker Edge options newsletter. Dan has more than 17 years’ experience in the options industry as a market maker, Options Institute instructor and author of “Trading Option Greeks.”