Investing logic highlights trading strategy

04/05/22
  • NVDA up Monday after pullback to breakout level
  • Investment strategy helps illustrate potential options trade
  • Vertical spread offers “targeted” strategy

Investing and trading may be different disciplines, but the principles of one can sometimes offer insights into the logic of the other.

Consider the “buy–write,” a common investment strategy that consists of buying a stock and simultaneously selling (“writing”) an out-of-the-money (OTM) call option. For an investor intending to hold the stock for a long time, the buy-write is a way to lower the entry price, or “cost basis.” For example, an investor who buys 100 shares of a stock at $50 while selling a $70 call for $1.20 effectively lowers the cost basis by the amount of the collected premium—in this case, to $48.80 ($50–$1.20).

The buy-write is simply a “covered call” strategy executed when the stock is initially purchased. Over time, an investor may repeatedly sell calls against a long stock position to generate additional income. The primary risk is that the stock will rally above the call’s strike price, the options will be exercised, and the investor will be forced to sell the shares.

A bull call spread can be thought of as the trading equivalent of the buy-write strategy used by investors.

If the strike price represents the investor’s ultimate price target, that’s not a risk at all. Also, investors may have the opportunity to buy back the stock at or near the strike price, although there’s no guarantee they’ll be able to do so. But in practice, the goal for most covered call traders is to sell options that are 1) far enough above the stock price that they are unlikely to be exercised by expiration, but 2) have enough value to justify the risk of exercise and having the stock called away.

The same logic and risks characterize a well-known options trading strategy—the vertical (bull) call spread. Like the buy–write/covered call, a vertical call spread includes a short OTM call. The difference is that the vertical spread’s time horizon is typically much shorter, the trader has a limited price target in mind, and a long call replaces the long stock part of the position. The bull call spread has limited risk (the cost of the spread) as well as limited potential profit (the difference between the strike prices minus the cost of the spread):

Chart 1: Vertical (bull) call spread risk-reward profile. Targeted bullish strategy.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


While the position’s limited upside wouldn’t interest a long-term investor—the spread’s profits stop when the stock reaches the short call’s strike price—it can be a viable choice for traders with shorter-term goals in mind.

The following chart of semiconductor stock Nvidia (NVDA) helps illustrate why. Last Friday the stock pulled back to test the breakout above its February–March highs after a strong rally off its mid-March lows:

Chart 2: Nvidia (NVDA), 12/20/21–4/4/22. Nvidia (NVDA) price chart. Pulled back to breakout point.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


A trader anticipating a near-term upswing—say, a move to challenge the March 29 high around $290—may have considered three basic choices yesterday:

1. buying the stock
2. buying call options
3. buying a vertical call spread

In this type of situation many traders would consider the main advantages of buying calls vs. buying the stock to be lower cost (lower margin for options vs. stock) and additional leverage, but long calls also have inherent disadvantages—namely, their limited lifespan and loss of value through time decay.

However, just as the short call lowers the effective entry price in the buy-write trade, it also lowers the cost of long exposure in a bull call spread. Yesterday, for example, an NVDA bull call spread consisting of a long May $275 call and a short May $290 call was trading for around 38% of the price of the May $275 call.

That discount means that the bull call spread’s percentage gain on any move up to $290 would be significantly higher than the long call’s gain, with the trade-off that the position wouldn’t be able to capture additional profits if the stock kept rising.

But again, that’s the difference between trading and investing. One can help shed light on the other, but different time horizons and profit goals still demand different strategies.

Market Mover Update: Another stock that recently tested a short-term breakout level, Block (SQ), jumped more than 8% intraday on Monday (see “Tech test”). Tech was front and center in yesterday’s market rebound—the Nasdaq 100 (NDX), which has led the market for the past three weeks, gained more than twice as much as the S&P 500 (SPX) on Monday.

Today’s numbers include (all times ET): Trade deficit (7:30 a.m.), Markit Services PMI (8:45 a.m.), ISM Services Index (9 a.m.).

Today’s earnings include: Acuity Brands (AYI), SMART Global Holdings (SGH).

 

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