Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Trading Plan
I bought five Xyz October 160–170 call spreads for $1.79. Here’s my trading plan:
Buy Xyz October 160–170 calls spread for $1.79
Max loss: $1.79
Max risk: $1.79
Max reward: $8.29
Ratio: 4.6 to 1
Stop-loss: If Xyz stock closes below $131
Profit stop: Exit three contracts @ tech stop $155 ($3.46 net credit exit) and let the other two contracts run.
Time stop: 30 days to expiration
Xyz as of today’s close: $152
Current value of spread: $3.00
What else should I build into my trading plans? This is when it gets difficult for me: When I’m winning I want to do too much (make a trade adjustment, watch the market live) because I’m excited. When I’m losing, I don’t even want to open my trading account and look at the balance.
First, let me say you’re doing the right thing by developing a detailed trading plan for your trade and at the same time examining the what-if scenarios. Next, let’s break your questions down into two parts: 1) the actual trade and 2) the psychology of trading options and spreads.
As for the trade, you bought the spread for $1.79. Therefore, you bought the lower strike (160) calls and also sold the higher strike (170) calls, paying a net debit of $1.79. Excluding commissions, your maximum risk is the debit and you will suffer the maximum loss if the stock closes at or below $160 at the October expiration. At that point, both of the calls are worthless. Your max profit is the difference between the two strikes, minus the debit, or $8.21, not $8.29. Nevertheless, your risk–reward is about 4.6 to 1.
It’s mid-July and the stock has obviously moved in your favor because the spread has widened to $3.00, or 67.6%. Since you picked the October expiration month, it is likely that you expect the stock to perform well throughout the remainder of the third quarter and therefore no adjustment is really necessary. Your trade is working out as planned and you might simply hold the position until you get to your price (155) or time (one month until expiration) stops.
On the other hand, if the stock has moved beyond your expectations and you want to take some money off the table, you might sell two or three of your five spreads now or at your target of $155 per share, which is less than 2% from the current market price of $152. You might also consider moving your stop-loss up and or closing the spread and opening a similar position in the 165–175 call spread, which will allow you to bank a profit and also maintain a bullish, but cheaper position.
There is no single correct answer, and the best course of action will depend on your outlook for the stock now that it has moved higher.
Now, as for building additional factors into your trading plan that might help with the psychology of trading, there are a few things you might consider. First, don’t commit too much capital to one trade or one type of strategy. If there are times when it really hurts to look at your account statements, you are probably taking on too much risk or you have too much money betting on market direction. Consider using a mix of strategies and not just positions that make money in bullish (or bearish) markets.
Second, realize that there are always more trades and more opportunities ahead. It’s easy to get preoccupied with one position or one stock when there is money being made or lost, but consider each trade as part of a bigger picture. You are not always going to win and even the most successful traders suffer losses. Keep things in perspective and don’t be afraid to cut losses or take profits. There will always be another opportunity to find a great trade.
Bull Call Spread Breakeven
If I pay $2.50 for an Xyz October 50–60 bull call spread, what is my breakeven? I thought it was $52.50, but my charting software shows a different number around $51.00.
The breakeven on a bull call spread will depend on the amount of time left until the options expire. In this example, the strategist is buying the October 50 call and selling the same number of October 60 calls. The debit of $2.50 is equal to the premium paid for the lower strike call minus the premium received for the higher strike call (commissions excluded).
If expiration is at hand, the breakeven will be equal to the lower strike price, plus the debit paid for the spread. So, the breakeven at expiration is $52.50 (50 + $2.50). At that level, the October 50 call has no time value remaining and a $2.50 profit, but the October 60 call is worthless. So, the strategist can pocket the $2.50 and breakeven on the trade.
However, it is possible that the spread will break even sooner and prior to expiration. The spread could find a breakeven point below the $52.50 level when there is time value still remaining in the option. In general, when we talk about breakevens, max risks, and max profits of a spread, we are referring to the risk profile of the position at expiration. Charting software like Optionetics Platinum can help investors see the breakevens on more advanced strategies before the options expire.