At first glance, buying a call option instead of shares might seem smart…
With call options, you can gain the same exposure to a stock at just a fraction of the cost of buying the shares.
And because your risk is limited to the amount you paid for the options, you are risking far fewer dollars per trade (compared to shares).
However, the downside of buying options is that the clock is always ticking away toward expiration…
If the move you were hoping for doesn’t pan out within your timeframe, the value of those options can soon disappear.
Buying a call option also increases your breakeven point. You need to recoup the cost of buying the option before your trade becomes profitable.
So the choice between buying shares and call options isn’t as clear cut as you might think…
Adding Another Leg
That’s where another options strategy – a “bull call spread” – helps swing the odds more firmly in your favor.
With a bull call spread, your trade has two parts. First, you buy a call option. Then, you write (sell) another call option at a higher price.
The key thing to remember is that you use the same expiry date with both options.
To see how a bull call spread works, let’s take a look at the chart of the S&P 500 Index (SPX) below… (Please note that the example below is not a trade recommendation.)
S&P 500 Index (SPX)
Source: e-Signal
On the chart, the Relative Strength Index (RSI) is tracking bullishly in its upper band (above the green line)…
SPX is also breaking higher. And the 10-day Moving Average (MA, red line) is beginning to accelerate above the 50-day MA (blue line), which is another bullish signal.
So to gain exposure to a developing up move, we can buy an SPX call option at 4230 (lower orange line at ‘1’) for $15.
That means the breakeven on our trade is 4245 – the option’s strike price (4230) plus the cost of the option ($15).
So SPX has to trade above 4245 before we make any profit.
Yet a second leg, a sold call option, helps lower our breakeven. That puts the odds more strongly in our favor…
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Working the Numbers
As the second leg of this trade, we write (sell) a call option at 4250 (upper orange line at ‘2’) and get paid $10.
Take another look:
S&P 500 Index (SPX)
Source: e-Signal
That lowers the breakeven on our trade to 4235. (We take our breakeven from the first leg – 4245 – and subtract the $10 we received for selling the 4250 call option.)
Since the spread reduces the cost of the trade and lowers your breakeven, that could make the difference in whether your trade is profitable.
Of course, the spread does limit our profit potential too.
The maximum we can now make on the trade is the difference between our options’ strike prices (4230 and 4250 = 20), minus the money we paid out for the spread ($15 spent – $10 received = $5). 20 – 5 comes to $15.
Remember, each options contract represents 100 shares. So that equates to a maximum profit of $1,500 per contract.
It’s a balance…
By placing the spread, you are giving up the potential for larger profits if SPX rises above 4250. But in exchange, you get better odds for profiting on your trade.
And with the right setup, that trade-off can be worth it.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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Are there any other options strategies you’re interested in learning more about? Send in your ideas to [email protected].