I have been knocking out Trade Alerts to buy vertical bull call spreads faster than a one armed paper hanger this year, so I thought I would take a time out to explain the logic behind them.
For those readers looking to improve their trading results and create the unfair advantage they deserve, I have posted a training video about How to Execute a Vertical Bull Call Spread.
This is a matched pair of positions in the options market that will be profitable when the underlying security goes up, sideways, or down small in price over a defined period of time.
It is the perfect position to have on board during markets that have declining or low volatility, much like we experienced in 2014, and are currently seeing.
I have strapped on quite a few of these babies across many asset classes this year, and they are a major reason why my performance is positive.
To understand this trade, I have used the example of an Apple trade, which I executed on July 10, 2014. I then felt very strongly that Apple shares would rally strongly into the release of their new iPhone 6 on September 9, 2014.
So followers of my Trade Alert service received text messages and emails to add the following position:
Buy the Apple (AAPL) August, 2014 $85-$90 in-the-money vertical bull call spread at $4.00 or best
To accomplish this, they had to execute the following trades:
Buy 25 August, 2014 AAPL $85 calls at……………$9.60
Sell short 25 August, 2014 AAPL $90 calls at..…….$5.60
This got traders into the position at $4.00, which cost them $10,000 ($4.00 per option X 100 shares per option X 25 contracts).
The vertical part of the description of this trade refers to the fact that both options have the same underlying security, AAPL, the same expiration date, August 15, 2015, and only different strike prices, $85 and $90.
The breakeven point can be calculated as follows:
$85.00 Lower strike price
+$4.00 Price paid for the vertical call spread
$89.00 Break even Apple share price
Another way of explaining this is that the call spread you bought for $4.00 is worth $5.00 at expiration on August 16th, giving you a total return of 25% in 26 trading days. Not bad!
The great thing about these positions is that your risk is defined. You can’t lose any more than the amount you put up, be it $10,000, $1,000, or $100.
If Apple goes bankrupt, we get a flash crash, or suffer another 9/11 type event, you will never get a margin call from your broker in the middle of the night asking for more money. This is why hedge funds like vertical bull call spreads so much.
As long as Apple traded at or above $89 on the August 14th expiration date, you would have make a profit on this trade.
As it turns out, my read on Apple shares proved dead on, and the shares closed at $97.98 on expiration day, or a healthy $8.98 above my breakeven point.
The total profit on the trade came to:
($1.00 X 100 X 25) = $2,500
This means that the position earned a 25% profit in little more than a month.
Occasionally, these things don’t work and the wheels fall off. As hard as it may be to believe, I am not infallible.
So, if I’m wrong, and I tell you to buy a vertical bull call spread, and the shares fall not a little, but a lot, you will lose money. On those rare cases when that happens, I’ll shoot out a Trade Alert with stop loss instructions before the damage gets out of control.
That stop loss is usually at the lower strike price when there is still a lot of time to run to expiration, as the position still has a lot of time value, and the upper strike price when there is only days to go to expiration.
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