Bullish Option Trade

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Could, Woulda, Shoulda

Finding the Right Bullish Option Trade

 

Coulda, woulda, shoulda. Back in early March, the S&P 500 along with a lot of individual stocks hit their lows. Who would have thought the market could make such a strong comeback? Actually, a lot of people did. The problem is that many of them made bullish option trades that resulted in a sub-optimal performance. Let's take a look at some of the bullish option trades that a trader could have made and consider, in hindsight, what a trader should have made.

On March 2, 2009, the SPX closed around 700. Now with the market at around 1050.78 as of the close on 9-24-09, it is up about 50 percent. That's a nice move to capture. Traders looking for a rebound around that time had a lot of bullish option trades available. Let's look at three broad categories of bullish option trades: selling puts, buying calls and bull call spreads.

Bullish Option Trade: Selling Puts

Conventional wisdom back in March would have suggested that selling in-the-money puts would have been the bullish option trade to make. Put sellers would have stood to make money two ways: positive delta and selling high implied volatility. An in-the-money put like, say, the 750s were trading at 113.40 on March 2. As of now, they are poised to expire worthless. That means the $11,340 collected per contract would be all profit (after factoring in commissions). Traders looking for a big jump, though, may have sold a deeper ITM put, like say the 850 puts. They would have had a beefier delta and still have enough short time premium to profit from the falling volatility. Trading at 179.70, these puts would have had 29.70 of time value. Again, these puts also are looking to expire worthless. In hindsight, the 850 puts would have been better than the 750 puts in terms of profit. But either of these bullish option trades had a lot of risk. If the market continued down, it could have been ugly.

Bullish Option Trade: Buying Calls

True, it may have seemed illogical to some at the time to buy such a historically high implied volatility (VIX was up around 50, though longer dated SPX options were priced a little cheaper in terms of IV). But smart traders looking for a move the magnitude of which the market actually ended up seeing (again, around 50 percent) didn't really care about buying historically high IV--and rightfully so. They would have made such a big percentage profit that the rich premiums would have been an acceptable cost of leverage.

The September at-the-money calls, which back in March were the 700s, were trading around 83--a 43 percent IV, but (in hindsight) that's OK. At some point during expiration week, they were 323 bid. A trader could have hit the bid and locked in a 240 gain per contract. In the SPX, that's $24,000. Compared with the original $8,300 investment, that's about a 289 percent profit. And the risk would arguably have been less than it would have been for a put seller. Long calls have risk limited to their purchase price.

A trader could have made a bullish option trade using the out-of-the-moneys too. The 850 calls were trading at 32.50. Being 173 bid a little over a week to expiration, that would have resulted in a 140.5 profit, or 432 percent. Because they were cheaper, the 850s had less nominal risk than the 700s too. However, one could argue that they are a bit more aggressive being further out of the money with less of a chance of expiring with any intrinsic value.

The 950s were trading at 12.50 in March. They could have been sold at 74.70 a week or so before they expired. That's a 62.2 profit, or about 510 percent. Less nominal risk still and a bigger percentage gain than the other long call choices mentioned here.

Bullish Option Trade: Bull Call Spread

Much of the time a bull call spread is a better bullish option trade than an outright long call. Why? Less nominal risk because one option is purchased while another is sold to offset some of the cost and time decay and volatility risks can be partially hedged off. Let's see how bull call spreads would have fared under the prevailing market conditions.

The 700-850 bull call spread could have been established for 50.50. These days it's trading for parity, or 150. That spread would have resulted in a 99.5 profit, or 197 percent. That's OK, but not as good as the outright calls. Why? The short strike that was sold was too low for what actually materialized in the market. Too much upside was given up. How about selling a higher strike?

The 700-950 may have worked. The 950s were around 12.50 in March. A lower premium to sell than that of the 850 calls, but still enough to offset the cost of the 700s to some degree. Any strike higher than that would not have been worth selling from a risk reward standpoint. The 700-950 call spread could have been bought for 70.50. Assuming that spread expires best-case-scenario--at 250--the result is a 179.50 profit, or 255 percent. Again, better than a proverbial poke in the eye with a sharp stick, but still not as good a bullish option trade as the outrights.

Lessons From the Past

This has been a case study in which the reader knew that the market was to rise strongly. It was not to say "Look how great these trades are!" but to compare three different types of bullish option trades from a risk reward perspective to show the importance of selecting the right strategy. Each trade was profoundly disparate in both its risk and potential reward from its alternatives. In the end, some trades lead to profits and some go astray. Unfortunately, only time tells what's in store for each trade. Trades must be constructed so that profitable trades have the greatest profit potential and losers have the lowest risk possible compared to the available alternatives. Leaving too much money on the table or risking more than necessary adds up. It can ultimately make the difference between success and failure in the long run.
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Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Option (ODD) which can be obtained from your broker; by calling (888) OPTIONS; or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606. The content on this site is intended to be educational and/or informative in nature. For simplicity, commissions are not included in the examples used. No statement in this article is intended to be a recommendation or solicitation to buy or sell any security or to provide trading or investment advice. Traders and investors considering options should consult a professional tax advisor as to how taxes may affect the outcome of contemplated options transactions.