Targeted options play

Consider a common market scenario: A trader thinks a stock may rally in the near term, but isn’t interested in owning the stock on a long-term basis.

Specifically, the trader thinks the stock may rally after the company releases earnings in a couple of weeks—but, wary of the possibility of a down move, the trader is considering buying call options instead of the stock.

By purchasing calls, the trader gets a position with limited risk, no matter how much the stock may fall. Of course, that peace of mind comes at a price. First, all long options lose value over time, regardless of what the underlying stock does. Second, with earnings fast approaching, the stock’s implied volatility (IV) is higher than average, which has inflated its options premiums. In effect, the trader may be paying an extra “premium” to trade call options instead of the stock.

We can get a better sense of why this is the case by looking at one stock, The Trade Desk (TTD), which is scheduled to announce earnings on May 8. The stock has consolidated in recent days after falling as much as 68% from the record high it hit early December. The decline was punctuated by a sharp sell-off after the company’s last earnings release, in February:

Around 2 p.m. ET on Wednesday, TTD was trading a little below $51, and an at-the-money $50 call expiring on May 30 was trading around $565. That means a trader who bought the call—which would be losing value every day because of time decay—would need the stock to be at $55.65 or higher (at expiration) to have any chance at a profit.

For the sake of argument, let’s say our trader didn’t necessarily expect the stock to rally much beyond that level in the near term. In that case, simultaneously selling a higher-strike call with the same expiration could help offset two of the long call’s drawbacks—its high price tag and its loss of value over time.

In this case, the $55 call was trading around $350 at 2 p.m. on Wednesday. Shorting this option while buying the $50 call creates a “vertical” call spread that gives the trader long exposure at a lower cost—$215 instead of $565. The result is a limited-reward, limited-risk bullish position:

The risk is capped at the cost of the spread, while the profit is capped at the difference between the spread’s strike prices, minus the cost of the spread. Overall, the trader gets a position that can 1) benefit (on a limited basis) from an up move in the stock, 2) is cheaper than an outright long call position, and 3) offsets some of the long call’s time decay.

It’s not a “perfect” solution, because there’s no such thing in the markets. But in the right situation, it can be an attractive choice for traders with limited time and price horizons.

Today’s numbers include (all times ET): durable goods orders (8:30 a.m.), weekly jobless claims (8:30 a.m.), Chicago Fed National Activity Index (8:30 a.m.), existing home sales (10 a.m.), EIA Natural Gas Report (10:30 a.m.).

Today’s earnings include: American Airlines (AAL), Bristol-Myers Squibb (BMY), Freeport-McMoRan (FCX), Keurig Dr. Pepper (KDP), Southwest Airlines (LUV), Merck (MRK), PepsiCo (PEP), Procter and Gamble (PG), Union Pacific (UNP), Alphabet (GOOG), Intel (INTC), Verisign (VRSN).

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.