A fellow stockbroker introduced me to options trading in the early-90s. I was a rep for a regional firm and he showed me how he created vertical call spreads on stocks that were possibly due to announce stock splits. The idea was to make money on the call spread from the move higher in the stock because the research supports the notion that shares tend to perform well leading into a stock split announcement, when the split is announced, and in the two weeks that follow. Trading stock split candidates today isn’t a worthwhile idea, however, because we’re not seeing many split announcements. But, the bull call spread is a viable strategy, with clear risks and rewards, on stocks that are expected to move higher in the months or years ahead. Using the search box, I picked a random example of a call spread from the Premium Alerts section. It’s a longer-term call spread that was initiated on Boeing (BA) on June 1.
Shares were trading around $67.50 at the time and investor bought a Jan2014 67.5 – 90 call spread on the aerospace giant for $7.35, 2000X on PHLX. In this longer-term spread, the focus is on the 2014s. The investor bought 2000 67.5 strike calls for $9.85 and sold 2000 90 calls at $2.50. The strategist is basically buying at-the-money 2014 calls and selling deep out-of-the-money calls. The debit is at risk if BA holds at $67.50 or less and the position is left open through the expiration. At that point, both contracts expire worthless and the premium paid is lost.
The maximum potential profit from a vertical call spread is always equal to the difference between the two strikes minus the debit. In this case, the spread is 22.5 points and therefore the potential profit is $22.50 – $7.35, or $15.15. Therefore, on one spread, the risk is $735 to make $1,515, a ratio of more than two-to-one. The max profits happens if shares settle at $90 or more through the January 2014 expiration, which represents a 33.3 percent gain over the next 18 months. The breakeven of a bull call spread at expiration is the lower strike plus the debit or, in this example, $74.85.
Like any options strategy, a bull call spread can be closed out at any time prior to the expiration. BA lost 9 cents to $71.90 today, but is up 6.5 percent since the trade was established two weeks ago. The spread can be offset by selling a Jan14 67.5 – 90 call spread at $8.50 (today’s market), to close. So far, the trade is working out well and judging by the open interest is still open. It’s a plain vanilla call spread that makes a lot of sense in bullish markets. It’s also a reason why we monitor the options order flow to find trading ideas and opportunities. First we find the trades. The next steps are to analyze and execute the trades if the risk-rewards fit well within our longer-term trading plans.
About the Author (Author Profile)
Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.