For the last few weeks I’ve been writing about what an investor could do to lock in some profits from the big rally of the last four years, and yet stay in the game in case prices kept marching higher. We looked at keeping our stock and buying protective puts. We also talked about selling our stock and buying call options. Last week I promised to examine some additional bullish alternatives.
Implied Volatility (IV) had been very low. This is another way of saying that options had been cheap. In that situation, we’ve been looking at debit trades, which involve being long options (puts and/or calls). We’ve excluded credit trades, which would be short options, such as covered calls or cash-secured short puts. Selling options while they were very cheap did not make sense. We wanted option buying strategies instead.
It may be timely to wrap up the discussion of bullish debit plays now. Since my last column, the S&P dropped almost 5%, and began making lower lows and lower highs. IV rose, to about 18%, which is about in the middle of its range over the last year. Going forward, we’ll be looking at strategies that are more neutral as to IV.
But first let’s finish exploring the main bullish debit plays. The remaining ones include the following:
- Bull Call (Vertical) Spread (Long a call, short another call with a higher strike, same month)
- Bullish Horizontal Spread (Long a call, short another call with the same strike, different months)
- Bullish Butterfly (Long one call, short two at a higher strike, long one even higher strike)
- Diagonal Call Spread (Long one call, short another call, different strikes, different months)
- Call Ratio Backspread (Long calls at one strike, short a smaller number at a higher strike)
Each of these involves buying call options as our anchor unit (the part of the position that we expect to make money). So far, that is the same as just buying calls alone, which we discussed last week.
But each of these positions also includes one or more offset units. The offsets are additional options that reduce, or offset, some of the unwanted characteristics of the anchor units. The main unwanted characteristic is negative cash flow. Selling the offsets helps pay for the anchor units.
Selling calls against our long (purchased) calls also reduces our exposure to volatility. We buy some time value in the long calls, but we sell some, too, in the short calls. Our net amount of time value owned is reduced. Since changes in volatility affect only time value, the less time value we own, the less we’ll be affected by changes in volatility.
The five alternatives represent different sets of trade-offs. Selling the offsets does reduce cost and volatility risk, but in most cases it also removes our unlimited upside potential. If we believe that in the near term the market’s upside movement will be limited anyway, then giving up something that we believe we won’t get may be a good deal. Kind of like dieting by cutting out broccoli.
To compare these, let’s assume that we started with a thousand shares of SPY, which we’ve now sold as of June 6, receiving $162,730. Say that we want to look out three months, to September, 2013; and that we are willing to spend a total of about 5% of our bankroll, or about $8,000, to stay in the game. We think that SPY could continue higher. As an alternative to just buying calls, we want a position that is cheaper. Since we know that that means selling other calls as offset units, we want to terminate this position about 45 days out. The last 45 days of an options life is when its decay really accelerates, so our offsets will have the greatest effect at that range. We’ll use July 19, the expiration date for July options, as our target date.
Below are the payoff diagrams for each of the five spreads. For each one, the lower strike price is $160, a little below the current price around $162. The upper strike is $170, the highest we think SPY is likely to go in the next 45 days. On each diagram, the blue arrow shows the current price.
Each position has been sized to risk about $8,000 at maximum loss. Which one we’ll choose will depend on how bullish we are on SPY’s price and on its volatility. Check out the P/L charts:
Figure 1 – Bull Call (Vertical) Spread
Buy 16 Sep 160 Calls @ $6.69, Sell 16 Sep 170 Calls @ $1.71
Figure 2 – Bullish Horizontal Spread
Buy 58 Sep 170 Calls @ $1.76, Sell 58 Jul 170 Calls @ $0.39
Figure 3 – Bullish Call Butterfly
Buy 20 Jul 160 Calls @ $4.80, Sell 40 Jul 170 Calls @ $0.39, Buy 20 Jul 180 Calls @ $ 0.03
Figure 4 – Diagonal Call Spread
Buy 12 Sep 160 Calls @ $6.69, Sell 12 Jul 170 Calls @ $0.39
Figure 5 – Call Ratio Backspread
Buy 15 Sep 160 Calls @ $6.69, Sell 10 Sep 170 Calls @ $1.71
From these pictures we can see that:
1. Maximum loss for all of them is about the same, around our $8,000 budget. The number of contracts has been chosen to accomplish that. For all of them, we would plan not to let that maximum loss occur. We’d place orders to unwind the positions if SPY drops below the next major demand level at around $154. At that price, here are the maximum losses, assuming no major IV change: Vertical, $6400; Horizontal, $7500; Butterfly, $8000; Diagonal, $6300; and Backspread, $6800. For comparison, just buying the $160 calls alone would result in a loss of the whole $8000 if SPY were anywhere below $160.The Bull Call Vertical Spread (Figure 1) and the Diagonal Call Spread (Figure 4) have similar profiles, capping off maximum profit above a SPY price of $170. The max gain on the Diagonal is $ 6,195 (with no change in IV), compared to $8,032 for the vertical. But at our 7/19 target date (blue lines), the diagonal would reach its max profit at a lower price. And unlike the vertical, the maximum profit on the diagonal could increase if IV increases. Of the two, the Diagonal would be a better bet if we thought a large increase in IV were probable; otherwise the vertical.
2. The Bull Call Vertical Spread (Figure 1) and the Diagonal Call Spread (Figure 4) have similar profiles, capping off maximum profit above a SPY price of $170. The max gain on the Diagonal is $ 6,195 (with no change in IV), compared to $8,032 for the vertical. But at our 7/19 target date (blue lines), the diagonal would reach its max profit at a lower price. And unlike the vertical, the maximum profit on the diagonal could increase if IV increases. Of the two, the Diagonal would be a better bet if we thought a large increase in IV were probable; otherwise the vertical.
3. The Bullish Horizontal Spread, also known as a Calendar Spread (Figure 2) and the Butterfly (Figure 3) are similar, in that profit peaks out at SPY 170 and declines at higher prices of SPY. For these spreads, it’s the green lines that show the P/L picture at our July 19 target date. The max profit on both of them is thousands of dollars higher than for the Vertical or the Diagonal. It’s about $10K for the Horizontal and $11K for the Butterfly; but that max profit is not very likely. It only occurs at the exact price of $170, so we would have to make sure and exit either of these two positions if that price is reached. Also, the max profit will be realized only if that $170 price is reached on exactly July 19. Any earlier than that, and the profit will be lower. The position of the blue lines (today’s P/L line) far below the green July 19 P/L lines shows that. The Butterfly would be hurt by increasing IV. The Horizontal is helped by increasing IV. They both would show a loss at any high SPY price. So between the two of those, the Butterfly would be the choice if we believed that IV could decrease from here, or if we thought it very likely that SPY would end up right at $170 on July 19. Otherwise, the Horizontal would be the clear choice between the two. Either of these two would make more than the Vertical or Diagonal if SPY did not exceed $170 by our target date.
4. The Call Backspread (Figure 5) is the only one of the lot with unlimited upside. This is accomplished by buying more calls than are sold, so that some of the long calls are “naked,” not offset by any short calls. The price of this unlimited upside is lower profit than any of the alternatives unless SPY does in fact go much higher. While all the others peak out at SPY $170, they make from $6-14K at that price. The Backspread makes only $5K. SPY would have to climb above at least $172 for the Backspread to pay better than the worst of the others. But beyond that, it leaves the others in the dust. The volatility picture for the Backspread is also heavily dependent on a SPY price increase. Unless SPY climbs above the Theta Switch Point around $168 (where the blue and green lines cross), a drop in volatility will hurt the position. Beyond that price, dropping IV actually helps. Since rising prices and dropping IV often go together, the Backspread will be a winner if, and only if, SPY really moves – beyond $172. If we strongly believed that, the Backspread would be the hands-down choice.
5. All right, already, so which one is best? As always – it depends. If we were extremely bullish, and believed that SPY $172 or better was likely by July 19, the Backspread would get the nod. If not, it comes down to how fast we think price will move and what IV will do. Fast movement will be OK for the diagonal and the vertical; if accompanied by increasing IV (unlikely) the diagonal will be the better of the two. If we think price could stall and move slowly, the Horizontal will be the winner. For the record, my choice at this point (June 6) would be the backspread, for its good reward/risk and unlimited upside. As always, your mileage may vary.
Next week, a changing market may call for a new set of strategies. We’ll see what happens then.
For comments or questions on this article, contact me at firstname.lastname@example.org.