Not only the title of a hit 1973 movie and Oscar winning Best Original Score song but, especially during earnings season, may be how you feel about a stock you are regularly following and once held as having great bullish potential. Perhaps this is one of many stocks that had a nice run recently and you have to decide what to do next. You think it may falter but you don’t want to sell the stock short outright because if you are wrong you will have unlimited risk. What’s a trader to do in this case? One potential option a knowledgeable and qualified trader might consider is the sale of a call vertical spread.
Let’s take a look at a stock as an educational example that would fall into that category. We’ll use AIG (
The outright purchase of a put will work if the stock goes down far enough (past the strike plus the premium received). There is one primary drawback to the purchase of the put, and the primary drawback to any options purchase. Options are a decaying asset and as the time premium decays this can have a negative effect on the price of the option you are holding. To take advantage of the decaying effect of options you may wish to sell some calls on the stock. You are on the right path but doing so without protection can lead to the exact same problem as selling the stock naked which is you have theoretically unlimited exposure to the upside. This is why we want to discuss the short call vertical spread and please remember, although we are using AIG as our example, this strategy can be applied in any stock that has options.
With our original premise in mind (we think the stock has gotten ahead of itself and we believe there will be a turnaround) our next step is to pick a call to sell. I like to start with out of the money options or options without intrinsic value. In this case, I am focused on the Dec 52.5 calls. Remember, in a short call vertical spread the trade really is about the option you are selling. The only reason you are going to buy anything against it is to define your risk. Looking at our graphic you can see the Dec 52.5 calls with a theoretical price of $1.66 have just over a 47% probability of being in the money on expiration day. Therefore, they have approximately a 53% probability of being out of the money. I like where the trade is headed as options are at their core probabilities. Having a probability of greater than 50% is a nice place to start. The next step is to make sure we define our risk, in order to do so we want to purchase a higher strike call in the same month to maintain this as a vertical spread. In this case we can settle on the Dec 55 call. If we purchase this call we have a theoretical price of $0.71. So we would collect a credit of $0.95 on the spread, placing our break-even point on the spread at $53.45 (as we sold the $52.5 strike plus the $0.95 we receive).
Breaking this trade down further, it’s a good habit to immediately look at risk. We collect the $0.95 and the spread, if things go against us, can go to $2.50. Therefore, we are risking $1.55. Why would we do this? The reason lies in the probability. An easy way to figure out the probability of this is to take the total risk of the trade, or what the spread can go to, which in this case is $2.50 and divide our real risk of this trade which is $1.55 (Total Risk less premium received) and we come out with a total of 62.5%. This high probability makes this trade very interesting to me. I know I can make $0.95, risk $1.55 and have a 62.5% probability of making money on this trade. Please note this is before commission and the probabilities are based on $0.01.
Let’s take a quick review of the timing of this trade. As you can see, I focused on the December timeframe. There are many ways to go about this, but I believe these types of trades with a directional bias and rely on time decay of options, a nice time frame to consider is 20-70 calendar days. Our example is 51 calendar days. In our scenario if the stock goes down we make money. If it goes sideways we make money as long as the stock stays below our strike. If it goes up we have some room and remember our break-even is $53.45. The nice thing about this, as compared to shorting stock, is we know that if the stock rockets higher our risk is defined and we can be out at $55. There are some risks around early assignment of the option you are short, but one way to mitigate this is to think about closing the position a week or so before expiration. You will notice that, barring a dividend payment, the greatest number of assignment/exercises happens during expiration week. As you become more experienced you may be able to wait longer but in terms of a closing time frame for a position, the week before expiration is a nice guideline. But keep in mind that a short option can be assigned at any time regardless of the in the money amount.
Short call vertical spreads can be a powerful tool in a well-diversified portfolio. It is a great place to start in terms of multiple leg portfolios. This trade can make a lot of sense since you can define risk on the trade at the very beginning. As you increase your trading experience, you’ll look to put probabilities and time decay on your side and this type of trade is well worth investigating.
Past performance of a security or strategy does not guarantee future results or success. Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Options. Multiple-leg option strategies entail substantial transaction costs, including multiple commissions, which may impact any potential return. Probability analysis results in the thinkorswim platform are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade. At TD Ameritrade, transaction costs for trades placed online are $9.99 for stock orders, $9.99 for option orders plus a $0.75 fee per contract. Option exercises and assignments will incur a $19.99 exercise fee. Commentary and examples provided for educational purposes only. Should not be considered a recommendation for any specific security or strategy. Supporting documentation for any claims, comparison, statistics, or other technical data will be supplied upon request.
