An option for spreading risk

  • BILL bounced after approaching 2022 lows
  • February options volatility relatively high
  • Vertical spread balances long and short options

Some traders use options to take advantage of their additional leverage or to predefine a position’s risk, but fail to account for the specific risks options can sometimes add to a trade.

After falling 75% from its November 2021 all-time high of $348.50, last week (BILL) approached its 2022 lows around $90:

Chart 1: (BILL), 3/29/22–1/12/23. (BILL) price chart. Higher lows, but no uptrends.

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

For argument’s sake, let’s say a trader saw this as a successful test of support and thought the stock could extend its bounce—say, over the next two to four weeks. Instead of buying stock, though, the trader wanted to use options for the additional leverage.

Buying a call would be the most straightforward way to trade an expected up move, but in addition to the unavoidable loss of time value that all long options are subject to, some BILL calls arguably faced another potential hurdle in this situation: relatively high volatility.

Deciding that the January and early February options may not offer enough time for the stock to make its expected move, the trader chooses to trade the February monthly options (expiring on February 17). But the following chart shows the implied volatility (IV) in these options was a little above average, and toward the upper range of the next several expirations’ IVs:

Chart 2: BILL volatility constellation, 1/12/23. Feb. IV relatively high.

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

That high IV could mean these options are already somewhat pricey, which could make it more difficult for a long call to generate a reasonable profit even if the stock continues to climb.

Enter the bull (vertical) call spread—which, by adding a short call to the basic long-call position—offsets some of a long call’s inherent disadvantages. The typical approach is to buy an at-the-money call and short a higher-strike call with the same expiration (sometimes using a strike price at the level the trader the thinks the stock will reach): The short call will benefit from time decay and also from declining IV, thus offsetting some of the long call’s weaknesses.

The trade-off (there’s always a trade-off) is that the call spread’s potential reward is capped at the upper strike price—even if the stock continues to rally:

Chart 3: Bull call spread risk-reward profile. Short call offsets some of long call’s disadvantages.

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

But since the risk is also capped at the lower strike price, the vertical spread can, in the right circumstances, be a good way for risk-conscious traders to target short-term price moves rather than open-ended rallies.

Today’s numbers include (all times ET): Import and Export Prices (8:30 a.m.), Consumer Sentiment (10 a.m.).

Today’s earnings include: Bank of America (BAC), BlackRock (BLK), Citigroup (C), Delta Air Lines (DAL), JPMorgan Chase (JPM), UnitedHealth (UNH), Wells Fargo (WFC).


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