Credit: Shutterstock photoYou're an optimist. You're the kind of person who always thinks the glass is half full. Great! You think the recent market turmoil has been upsetting, but that clear skies are ahead. You think the current correction is just that, a temporary speed bump, and that the long-term direction of the market is up. You think the summer might be a little rocky, but all the arrows will be pointing up by fall. In today's column, we will suggest two basic ways to act on those beliefs and to make some bullish bets.
Long calls
This option strategy is pretty basic, and might even be familiar to novice option traders. In a long call, you are outright bullish on the underlying equity. You expect the shares to move higher during the life of your option contract, ideally beyond the strike price of your purchased call.
Only one option is involved in this trade -- a call, specifically, which you will buy to open . Let's say that fall is right around the corner, and you're upbeat about the prospects for Jackets Unlimited. The shares are currently trading at $15, but you expect that they can climb as high as $25 before encountering technical resistance.
You can buy in-the-money options if you're a conservative type, because these contracts have a greater probability of retaining intrinsic value at expiration. More adventurous traders can try their hand at out-of-the-money or at-the-money option trading, which provide greater leverage and a lower cost of entry. In the case of Jackets Unlimited, you decide to buy to open an at-the-money, 15-strike call.
To give the shares ample time to move as you expected, you make your trade a few months out, in the September series. Your initial cash outlay will be equivalent to the ask price of the option, multiplied by the number of contracts you'd like to purchase, multiplied by 100 (because each option contract gives you control over 100 shares of the underlying). With a September 15 call currently asked at $0.90, you'll shell out $90 to buy one contract.
The good news? This initial investment is the most you can lose, even if the stock's price takes a serious dive. In this scenario, your easiest option (no pun intended) is to simply let your call(s) expire worthless, without taking any action to close the trade. Once the option expires, your trade is effectively closed out, and you can move on to new opportunities.
In order to determine the breakeven point of your trade, simply add the price of your option contract ($0.90) to the strike price of the option ($15). Once Jackets Unlimited surpasses $15.90 on the charts, you'll start making money on your trade. From this point on, your profit potential is unlimited .
Assuming the shares move as you expected, let's say that Jackets Unlimited is trading at $25 by the time September expiration rolls around. Your option contract now carries 10 points' worth of intrinsic value, or $10. You can sell to close the option for a price of $1,000.00 ($10 x 1 contract x 100 shares), resulting in a profit of $910. Or, you can exercise the option in order to purchase 100 shares of the stock at a notable discount to the current market price. If you prefer the second choice, you should be aware that equity options which are in the money by at least one-quarter of a point upon expiration will be automatically exercised.
Now that we've got this basic bullish strategy down, let's review another optimistically oriented strategy.
Long call spread
In a long call spread, you will buy a call and sell a higher-strike call . (When you take up the selling end of a call trade, remember that you are on the hook to deliver 100 shares of the underlying per contract in the event that you are assigned.) This strategy is well-suited for bullish traders who have a specific upside target in mind for the equity involved.
Returning to Jackets Unlimited, you could implement this strategy by buying to open an at-the-money 15-strike call. Since you believe the stock's rally will stall at $25, you sell to open a 25-strike call. The premium you collect from the sale of the higher-strike call will partially offset the purchase of the lower-strike option, effectively lowering both your breakeven and your cost of entry for the trade. Because this type of spread is opened at an initial net debit, it's also referred to as a debit spread .
In the best-case scenario, the stock will rally right up to the strike of your sold call, and then stop moving altogether until expiration. This means that you've attained the maximum profit on the purchased call, and you can let your sold call expire worthless, without taking any action to close out or cover the position.
If the stock does rally above the sold strike, your purchased call effectively covers your obligations as a call writer -- the latter can be exercised, allowing you to buy stock at a discount and deliver the necessary shares to the option buyer.
Meanwhile, if the trade goes completely haywire and the shares tank, your losses are limited to the initial net debit paid. But, in order to secure that limited downside risk and the lowered cost of entry, you do have to sacrifice some upside potential. Your maximum profit is limited to the difference between the two strikes, minus the net debit you paid to enter the position (and any brokerage fees, naturally). Since your profit is capped by the sold call, don't use this strategy if you're out-and-out bullish -- try a long call instead.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
