Markets seem to be chopping around the last few sessions… but that will all soon change as we approach earnings season this Friday, lead by the commercial banks.
Now, I don’t usually trade earnings, but I did last quarter with some success, and will probably trade a few this quarter. Maybe score some winners like TTD.
That said, I want to talk to you about trading options during a catalyst event like earnings release.
You see, buying calls and puts can be risky because option premiums get elevated. Whenever there is uncertainty, and the market is expecting a significant move, they’ll juice up option premiums to reflect that.
It can create a situation where a trader buys call options on a stock, the stock moves in their direction but the option loses value. This happens if you don’t understand the role that time, volatility, and strike price selection in options, click here for a primer if you need a refresher.
However, the cool thing about options trading is there are workarounds. For example, while it might be expensive to buy calls or puts ahead of an earnings event, you could make a spread trade where you buy one option and sell another one to offset the cost and reduce the role that volatility plays in the option price.
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Difference Between Long Call and Bull Call Spread
The beauty of options is the fact it allows us to use multiple strategies to our advantage… no matter what outlook we have on a stock or exchange traded fund (ETF). With stocks and ETFs, you can either go long (buy) or short (borrow shares to short sell).
However, with options, you can be bearish, bullish, or neutral.
For example, if you’re bullish on a stock or ETF, the most basic options strategy would be to buy call options. If you don’t already know, a call option gives you the right to buy a stock at a specified price (the strike price)… on or before the expiration date. If the stock or volatility rise, your options would benefit. But keep in mind, when you’re net long options (either calls or puts), time decay will eat at the option premium.
Basically, with a long call option position, you want the stock to explode.
But what if you’re neutral to bullish, and only think the stock can rise to a specific price (like a resistance level)?
Well, there’s a more suitable strategy… that also reduces your cost basis.
Bull Call Spread
Now, traders use the bull call spread when they think the price of a stock or ETF will run up modestly in the near term.
The strategy is constructed by purchasing in-the-money (ITM) call options, while simultaneously selling the same number of out-of-the-money (OTM) call options.
Since this strategy involves selling OTM call options, it helps to reduce the cost basis of the bullish position. However, if the stock explodes… your profits are capped. So there’s a give and take with this strategy.
Here’s a look at the profit and loss (PnL) diagram of the strategy.
Bull Call Spread Max Profit
Your maximum profit is achieved when the price of the underlying stock is greater than the strike price of the short options. For example, let’s say a stock is trading at $50, and you think the stock can rise 10% within the next month.
Well, you can buy 1 ITM call option, say with a strike price of $48, while selling 1 OTM call option at $55. Well, if the stock actually rises more than 10% and gets above $55, your max profit is achieved.
Now, the maximum profit is calculated as:
- Strike Price of Short Call – Strike Price of Long Call – Premium Paid – Commissions
Similar to the long call strategy, the bull call spread has limited downside risk.
Bull Call Spread Risk
The max loss happens when the price of the underlying stock or ETF is less than the strike price of the long call. Sticking with the previous example, if the stock close below $48 on the expiration date… well, that’s your max loss.
Your max loss is just the premium you paid to execute the trade, plus commissions.
Is the Long Call Better than the Bull Call Spread?
You might be wondering, “Well Jeff, is one strategy better than the other?”
You see, there are specific scenarios where you would want to use the long call, as opposed to the bull call spread.
For example, here’s a look at the SPDR S&P 500 ETF (SPY), when it tested a level of support (the 200 day simple moving average – the green line).
The green line served as a line in the sand for the market for quite some time. Let’s say you were bullish on the market, but only thought it could rise to $290, a resistance level. Well, the bull call spread would be better than just buying calls outright.
You see, just buying calls would’ve been expensive… However, with the bull call spread, you’re reducing your cost basis by selling OTM calls.
But when would you use just the long call option?
Well, when you’re really bullish on a name, or see an indicator – like the money pattern – signal a stock can pop.
For example, here’s a look at an hourly chart on Roku (ROKU)… when it made sense to just buy call options.
With stocks that can run… you don’t always want to cap your upside. For example, you can clearly see ROKU can run up significantly in a short period.
Source: WeeklyMoneyMultiplier.com | Original Link