A lot of options traders have a common path when it comes to their understanding of options strategies. The first trade that they will typically do is a long
call. The long call gives them the potential to make a lot of money with a relatively small amount of risk. The maximum profit is theoretically unlimited –
assuming the stock goes to infinity. And the risk is limited to the debit spent to purchase the option. Long calls can be appealing. The problem is that
they, usually, lose money.
The first option “spread trade” that traders tend to discover after the long call is the bull call spread, a.k.a. call vertical debit.
The structure of the bull call involves buying an out of the money long call and selling another call at a higher strike. The trade is a debit trade, and
the maximum loss is the debit. The maximum profit is the difference between the spread of the strikes (short call strike and the long call strike) and the
debit of the trade. If the trade is structured out-of-the-money, the maximum profit is much greater than the maximum risk. That is good!
The trade is similar to a long call; it has a very good risk to reward profile. The difference is that the bull call is cheaper. You can think of it as
using the short call to help offset the price of the long call. The short call lowers the price of the trade. However, it also caps the maximum profit.
This makes the bull call spread appealing for stocks that have a very bullish move. It is not unreasonable to see a 200% or 300% maximum return on
investment if the stock moves very bullishly.
While the risk/reward is excellent, trade has a low probability of working. The probability is better than a long call. However, still, it is pretty low.
It would not be uncommon to see the probability of profit in the range of 25% – 40%.
Since the long call is the primary instrument, the trade is theta negative. That means that the trade loses money with time. So, the longer it takes for
the stock to make a bullish move, the less of a chance the trader will have of making a profit.
That can be a slippery slope. When the stock does not move very bullishly, it will continue to lose value. Then, any bearish move can render the trade
At expiration, three things can happen.
Stock is above the short call strike – (recall that the short call is the higher of the two strikes). The trader will reap the maximum profit. That is
not the ugly part. However, still, if the stock is higher than the long call, it might be a good idea to close the trade early to avoid the potential of
the stock moving below the short call just before expiration.
Stock is between the short and long calls. In this case, the long call is automatically assigned, and the short call expires worthless. The assignment
will leave the trader with 100 shares of the underlying equity for each contract. Since the bull call is a trade that allows traders to use much less
capital than buying the stock, many traders do not anticipate the potential of assignment when they determine the size of the trade. If the trader does not
understand the assignment process, they can be surprised to find themselves with a sizable position in the underlying equity. (Traders should make sure
they understand the assignment process and talk with their brokers if they are unsure. That conversation should happen before expiration!)
- Stock is lower than the long call. The trade expires worthless at the maximum loss. Sadness ensues.
The ugly side of this trade is that it is more likely to lose money than make money. In addition to that, the trade can be tricky if assignment occurs.
Does this mean that you should discount this trade? Absolutely not! It has its place.
It is an ideal trade where you expect an explosive move. The trade has a lower cost than the long call and gives the trader the chance to make a sizable
return. Sometimes we refer to those sorts of trades as “Las Vegas Trades” because they are a gamble.
It is possible, however, to structure this trade so that you can get the best of both worlds: have the potential to make a big return in a very bullish
trend and also be able to adjust the trade if it goes stagnant or bearish.
To be able to do that the trader must setup the right trade, initially. At OptionANIMAL, we specialize in trade adjusting.
For our basic application of a bull call, we would look to have a long call that is at-the-money or slightly out-of-the-money and the short call one or two
strikes higher. We would also be at an expiration series that would have at least 45 days of time value when the adjustment is needed. For example, if you
were expecting a trade to make a very bullish move in the next two weeks, you would pick a series with at least 60 days of time value.
You define your primary exit as a percent return on investment (ROI) and close the trade when you hit that ROI, within two weeks.
If you do not hit your primary exit, you need to consider your secondary exits. That could be defining a percent net loss. Since no one likes to lose
money, we would look to adjust the trade into something that would make money in the current trend. That could include rolling the short call below the
long call to make a bear call spread (a.k.a., bear vertical credit spread.) That would make money in a stagnant to bearish trend. Alternatively, and
depending on the time remaining in the option, a trader may adjust into a call calendar or a call diagonal spread.
That is a very high level explanation of adjusting. There are more subtleties than could be explained here.
The key to success with this trade – and any trade – is to have a very well-defined trading plan. The trader must determine when to take profits (Primary
Exit) and when to take a loss or adjust the trade into another trend (Secondary Exits).