Balancing risks

Options can give traders flexibility they may not have when simply buying or selling stocks, but they can also introduce unforeseen complications and risks. One way experienced traders attempt to deploy options is to combine them in ways that help minimize risk without sacrificing too much flexibility.

For the sake of argument, let’s suppose a trader saw FedEx (FDX) fall to its lowest level since last June on Friday and decided the stock had the potential to rebound, at least temporarily:

But the trader also preferred, if possible, to construct a position with less risk than a simple long-stock position. Buying call options may appear to fit this bill, since their maximum loss is limited to their cost, but our trader may have decided this approach had certain downsides. First, all long options lose value over time because of time decay. Second, as the bottom portion of the chart above shows, on Monday FDX’s implied volatility (IV) jumped to a multi-month high above 42.

Because high/rising IV can make options more expensive, that means a long-call position could be fighting a two-front battle—against time decay, as well as potentially overinflated premiums. Since the stock would have to rally enough to offset the cost of the options before the position would begin to turn a profit, this could mean that even a trader who was correct about the stock’s direction could end up with a smaller-than-expected gain, or no profit at all.

At first glance, these disadvantages would seem to be erased by doing the opposite—that is, selling (shorting) options instead of buying them. For example, a trader who sold calls would get to keep all the collected premium if the stock rallied and remained about the option’s strike price until expiration.

The catch: Short options positions can produce unmanageable losses if the stock moves the wrong way. For example, if a trader shorted an FDX April $255 call and the stock declined instead of rallying, the trader could be looking at mounting losses on the option itself, and/or the risk of being assigned FDX shares at $255 in a falling market.

This is precisely why some traders use strategies that combine long and short options, such as vertical spreads. For example, a typical vertical “bull call” spread would consist of going long a roughly at-the-money call option while simultaneously shorting a call option with a high strike price and identical expiration.

For example, the following chart shows the profit-loss profile (at expiration) for an April $255-$270 bull call spread—long the $255 call and short the $270 call:

Notice the position’s potential profit and loss are both limited: the profit to the difference between the strike prices (15, or $1500) minus the cost of the spread (a little more than $600 around midday on Monday), while the loss is limited to the cost of the spread. Bottom line, the position provides upside exposure (with defined risk) in the event the stock rallies, although its gains are capped at the upper strike price.

Long options fight an uphill battle against time and falling volatility, while short options benefit as time passes and volatility declines. Combining long and short options in strategies like vertical spreads can, in the right circumstances, give traders more ways to potentially capitalize on a price move while managing risk.

Today’s numbers include (all times ET): S&P Case-Shiller Home Price Index 9 a.m. FHFA House Price Index 9 a.m., consumer confidence 10 a.m.

Today’s earnings include: DigitalOcean (DOCN), Home Depot (HD), Keurig Dr. Pepper (KDP), First Solar (FSLR), Intuit (INTU), Keysight Technologies (KEYS), Lemonade (LMND), Light & Wonder (LNW), Workday (WDAY).

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