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Today, we will look at another bullish strategy utilizing call
options with a debit posted to our broker account when we first enter the
trade. This strategy is also known as buying vertical calls. We will use
these terms interchangeably throughout this column.
By the end of Friday July 16th, 2010, the call option
chain for IBM stock for the month of August 2010 should look like the
following table:
|
August
|
2010
|
Option
|
Chain
|
for
|
IBM
|
stock
|
|
|
|
|
IBM
|
128.10
|
0.07
|
|
|
Calls
|
|
|
|
|
|
|
|
Strike
|
Symbol
|
Last
|
Bid
|
Ask
|
Volume
|
Open Interest
|
|
120
|
IBM82110C120
|
9.15
|
9.10
|
9.25
|
128
|
1520
|
|
125
|
IBM82110C125
|
5.20
|
5.20
|
5.35
|
984
|
2149
|
|
130
|
IBM82110C130
|
2.48
|
2.43
|
2.48
|
3117
|
6089
|
|
135
|
IBM82110C135
|
0.89
|
0.87
|
0.90
|
1786
|
9126
|
Notice IBM stock closed at $128.10/share, up $0.07/share. Let’s say
we are bullish about the stock and we want to use the Bull Call Debit Spread
Strategy. This strategy caps our loss and gain. The maximum loss is net
debit. The maximum gain is the difference between strike prices gap and
net debit. Hence, the lesser net debit, the more gain. To achieve maximum
gain, the stock has to close above higher strike price by the end of 8/20
trading day.
For the sake of simplicity, we will use last option price to
determine net debit. Let’s look at
three scenarios here:
1. Buy 120/125 vertical
calls: We buy 120 call and sell 125 call for a net
debit of $3.95/share or $395/contract. Our max gain here is $1.05/share
or $105/contract.
2. Buy 125/130 vertical
calls: We buy 125 call and sell 130 call for a
net debit of $2.72/share of $272/contract. Our max gain here is
$2.28/share or $228/contract.
3. Buy 130/135 vertical
calls: We buy 130 call and sell 135 call for a
net debit of $1.59/share of $159/contract. Our max gain here is
$3.41/share or $341/contract.
In scenario one, we buy ITM calls. This is a conservative trade.
The stock has to trade above $125 for us to achieve max gain. Notice IBM
already traded above $125/share when we enter this trade. Our profit in
scenario one is the least among the three scenarios but the probability
for a profitable trade is the greatest.
In scenario two, we buy ATM calls. The stock has to move pass
$130/share for us to achieve max gain. The profit is a bit more compared
to scenario one but the probability for a profitable trade is also a bit
less.
In scenario three, we buy OTM calls. This is an aggressive trade. The
stock has to pass $135/share for us to achieve max gain. Our profit is
the greatest among the three scenarios but the probability for a
profitable trade is also the smallest. If we are not careful, it is very
easy to lose money buying OTM options. It is said if we buy
out-of-the-money option too often, we will soon be out of money. However,
experienced and skillful option traders sometimes utilize this aggressive
trade. Chart reading ability is a must before we attempt such an
aggressive trade.
To achieve max gain in Bull Call Debit Spread Strategy, the stock
has to close above the higher strike price and both options
exercised. However, we can also
manually get out of the trade before option expiration day to recognize
our profit sooner. If that is the case, we will get less than max gain
profit.
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