Targeted options trading

03/10/22
  • THO up more than 8% intraday after earnings on Wednesday
  • Shares recently tested 22-month lows
  • Different considerations for options traders vs. investors

Because all options have limited lives and long options invariably lose value because of time decay, buying calls is far from an ideal buy-and-hold investment strategy. On shorter time frames, however, some traders may see advantages in buying calls instead of stock, especially in terms of the additional leverage options can offer. The key is to limit—as much as possible—the weaknesses of options, while structuring trades that make the most of their strengths.

We can use recreational vehicle maker Thor Industries (THO) as an example. After beating earnings estimates before the bell yesterday,1 THO jumped as much as 8.6% in early trading before paring its gains later in the session. But as the chart shows, the stock has fallen more than 40% over the past year, and recently tested its November 2020 low:

Chart 1: Thor Industries (THO), 8/18/20–3/9/22. Tested lows after one-year decline.

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


Let’s say a trader thought THO could continue to push higher—topping $95 in the near-term, and perhaps challenging its January highs around $109 over the next several weeks. With the stock trading around $91, the minimum (50%) margin requirement to buy 100 shares would be $4,550.

Someone considering buying calls to trade the up move would want to avoid two common pitfalls:

1. Buying options with too little time until expiration. Beyond the fact that the options need enough time for the expected stock move to unfold, options with just two or three weeks lose time value at an accelerated pace. In this case, the trader would likely avoid the March monthly options expiring on March 18 and focus on the April or June contracts.

2. Buying options that are potentially overpriced because of volatility. Because high and/or rising implied volatility (IV) typically inflates options prices (regardless of the stock’s movement), options buyers need to be careful about buying options with exceptionally high IV.

The following “IV constellation” comparing the IV of THO options (at different expirations) to their 30-day average shows that although the March options had higher-than-average IV (and thus, potentially inflated premiums), the April, June, and September options didn’t:

Chart 2: THO implied volatility profile. IV near 30-day avg. for April, June, Sept.

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


A Catch-22 here, though, is that IV levels, like prices, are relative—IV that is low compared to the past week or 30 days may still be high compared to the past year. And in this case, THO’s overall IV level was close to its highest level of the past year.

Now let’s look at THO options prices yesterday morning. When THO was around $91, an April $95 call was trading at roughly $680 per contract. Let’s say the trader turned out to be correct about a rally, and THO closed at $110 on April 15 (monthly options expiration). At that point the option would be worth $1,500 (the difference between the stock price and the strike price), which translates into a gain of $820—a 120.6% return on the cost of the option (excluding commissions).

A trader who bought 100 THO shares at $91 would be up $1,900 on April 15 ($110–$91 x 100)—a larger dollar gain than the long call position, but a smaller return on investment (ROI) in terms of margin ($1,900 ÷ $4,550 = 42% ROI). That illustrates the potential leverage advantage of an options position, but doesn’t address its drawbacks.

One way some traders try to offset some of the disadvantages of a potentially high–IV long call is to simultaneously sell a higher-strike call with the same expiration and create a bull (vertical) call spread. This position can be especially appealing to traders who, like our THO trader, expect a stock to make a relatively limited near-term up move. Traders often sell a call with a strike price near their price target—in this case, for example, combining a long $95 call with a short $110 call. The result: a position that’s cheaper than an outright call that can still profit from an up move:

Chart 3: Bull (vertical) call spread. Limited risk, limited reward, limited time horizon.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation. Does not reflect commissions or options costs.)


The drawback is that unlike a long stock or call position, a bull call spread won’t continue to profit if the stock keeps rallying. The profit maxes out at the upper strike price—but the loss is also capped no matter how far price falls below the lower strike.

Bottom line, the disadvantages of a long option can sometimes be reduced by combining it with a short option that benefits from time decay and potentially declining volatility.

Market Mover Update: PVH Corp. (PVH) padded its bounce with a 9% gain on Wednesday (see “Sell-offs and support”). A day after the US banned Russian petroleum imports, April WTI crude oil futures (CLJ2) posted their biggest one-day decline of the year (see “Oil on full boil”).

Today’s numbers include (all times ET): CPI (8:30 a.m.), Weekly Jobless Claims (8:30 a.m.), EIA Natural Gas Report (10:30 a.m.)

Today’s earnings include: JD.com (JD), LegalZoom.com (LZ), Limoneira (LMNR), Ulta Beauty (ULTA), Rivian Automotive (RIVN).

 

Click here to log on to your account or learn more about E*TRADE's trading platforms, or follow the Company on Twitter, @ETRADE, for useful trading and investing insights.


1 MarketWatch.com. Thor Industries stock surges as strong RV demand in North America leads to big earnings beat. 3/9/22.

What to read next...

03/09/22
Find out what traders may have noticed when the US banned Russian crude oil.

03/08/22
Stock’s sharp sell-off may look different to traders focused on the past couple of months instead of the past couple of years.

03/07/22
Stocks stall week after Russian invasion, commodities jump.

Looking to expand your financial knowledge?