Option trading is often advertised as an "explosive" way to double your money every week... while it may be true if you are lucky, this is very misleading. It's true an option can triple value in a single day but it may also lose all its value in the same period. Albeit the perfect claim for the next "get rich quick" scheme, options should be used as a hedge for a stock portfolio or as a speculative tool when used correctly. Options can be used to gain when the market moves up, down, stays the same or even when it moves in any direction. All my option charts are generated using Option Oracle, the best free stock options strategy analysis tool.
I'll start this series of option trading strategies with the Bull Call Spread, also known as a Vertical Spread. This strategy is used to make a profit when the underlying stock goes up. Good entry points are: at a bottom, near a support level before earnings when you have a strong positive bias.
The bull call spread is composed of 2 call options at the same expiration date:
- Long 1 call for the chosen strike price, usually at the money (ATM)
- Short 1 call for a higher strike price, usually out of the money (OTM)
Risk
The maximum risk for the strategy is the amount paid for the spread. There are no margin requirements. The maximum profit you can get from a bull call spread is limited to the difference between the strikes minus the amount paid for the spread.
Entry rules
- Bullish outlook for the underlying stock
- Buy options with at least 30 trading days left before expiration
- Aim for a 2:1 to 3:1 gain/risk ratio: about $1.25 to $1.65 for a $5 spread
Exit rules
- Close position at least 20 trading days prior to expiration
- Close position if value drops below 60% of initial purchase price
- Close half the position when 100% profit achieved; Close the remaining half when the spread is valued at 80% of the total value of the spread ($4 for a $5 spread)
Strategy graph
To better understand option strategies, a performance graph is very helpful. The following is an example for an underlying currently at $68:
- Long 1 Apr09 73 Call at 1.70
- Short 1 Apr09 76 Call at 0.93
The total debit for this position is $0.77 with a maximum gain of $2.23. The gain/loss ratio is thus 2.9. This position's value changes at the same rate as 11 shares of the underlying for a fraction of the price, this is called Delta.
Note: Options are evaluated using values called Greeks: Delta, Gamma, Theta, Vega and Rho. I will describe them in another post.
The performance graph for this position when bought:
Performance graph at expiration:
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