THE FIRST DATE
Option strategies, like people, are never one
size fits all, and there’s no one “best” approach. You can be right on a directional call,
but not make as much profit as you expected.
Why? You probably could have chosen a better strategy. A bullish long call vertical might
work in one scenario where the stock goes up
quickly, but not work in another where the
stock rises over a longer period of time. The
wrong strategy with the right stock might
not yield the desired results. When you trade,
first decide whether the stock might go up
or down, and how long it might take to do so.
Next, decide which strategy might yield the
best results if you’re right on
direction and timing.
Just as we each have our
GETTING TO KNOW YOU
own opinions about who
makes a good life partner,
two traders can look at the
same stock and see differ-
ent realities. You may both
consider the same news,
financial data, and charts. Yet, one may see a
short-term opportunity, while another sees a
long-term investment. So, the first decision—
direction and time—is up to you.
If your first decision is about what you’re go-
ing to trade, your second decision concerns
how. From the start, understanding strategy
mechanics will help you match trading deci-
sions to your outlook for a stock, and give you
a better idea of how the stock might respond
to changes in price and other factors.
You can use this thought process for just
about any option strategy: short calls, iron
condors, straddles, and so on. Here we’ll
focus on verticals—specifically, long verticals
as a bullish or bearish speculative strategy.
Verticals are a popular strategy for directional trading. They cost less than buying or
shorting a stock outright, they have defined
risk, and they can be flexible, letting you
select strikes and expirations to suit a stock’s
outlook. But all verticals don’t act the same
thanks to different expiration times.
Consider this example. Suppose stock
XYZ is trading at $135. Earnings are coming
up within a few days. You’re bullish on the
stock, and believe it might go up in the next
week. Using theoretical values, compare a
long 134/136 call vertical with seven days to
expiration (D TE), trading at $0.99, with a
long 134/136 call vertical with 45 D TE, trading at $0.98.
Assuming no change in implied vols, if
the stock rallies up to $136 in six days, the
134/136 call vertical that had seven DTE
would have a theoretical value of about $1.48.
The call vertical that had 45 D TE would have
a theoretical value of about $1.07.
The stock went up $1 in six days; the short-term vertical rose about 49%, and the long-term vertical rose about 9%.
If the stock falls $1 in six days, the theoretical value of the short-term 134/136 call vertical drops to $0.51, and the theoretical value
of the long-term 134/136 call vertical drops to
$0.90. The short-term vertical that had seven
DTE when established dropped about 48%,
and the longer-term vertical that had 45 D TE
when established dropped about 8%.
In both cases—stock goes up $1 and stock
goes down $1 after six days pass—the short-
term vertical had larger percentage gains and
losses. In other words, it’s more volatile and
gives you a larger profit when you’re right
(stock goes up), but a larger loss when you’re
wrong (stock goes down).
What if the stock’s price is at $135 after six
days? The theoretical value of the short-term
134/136 call vertical is $1, and the theoretical
value of the long-term 134/136 call vertical is
$0.99. Both are basically unchanged. This is
important when thinking about a longer-term strategy.
On the other hand, say you’re bullish on
XYZ, and you think it might take more than
a month to rally. Neither the short- or long-term 134/136 call vertical changes theoretical
value much over a week. Are you any worse
off buying the short-term call vertical for a
longer-term trade? Possibly so. Even though
the theoretical values don’t change much if
the stock price doesn’t change, you’d have to
reestablish the short-term call vertical maybe five more times to extend the duration of
the trade to match that of the vertical that
has 45 DTE. That can mean five times more
commissions and slippage.
The price of a vertical that’s closer to
expiration will respond more to a change
in the stock’s price, all things being equal,
than a vertical that’s further from expiration. This is true for verticals that are at the
money (ATM), where one option is in the
money (ITM) and the other option is out of
the money (OTM), as well as OTM verticals,
where both options are O TM; and finally for
ITM verticals, where both options are ITM.
Keep in mind the vol of a vertical’s price is
often higher the closer it is to expiration.
That volatility works both ways, of course.
Say you’re bullish on a stock in the short
term and you buy a call vertical with a few
days to expiration. If the stock goes down,
that short-term vertical will lose value more
With verticals, the greater the potential
reward, the greater the potential risk. Think
of that first perfect date with a globetrotter
who lives half the year in another country. The ensuing relationship isn’t always
Across a noisy market, crowded with symbols, your
eyes meet—well, metaphorically, anyway. With a flushed face and
beating heart, you discover it: that one stock or index or ETF that
rises above all the others. It piques your interest and beckons with
potential opportunity. Come to think of it, trading and love have a
lot in common. Both involve potential risk and potential joy. Just as
in romance, you might wonder how long the relationship will last.
With a trade, you have to start by applying the right strategy.