Lessons from the Pros

Creative Financing

Many times as I am looking at various charts, a trade just jumps at me. I was looking at various time frames on the chart of an unnamed underlying. First, I noticed on the monthly chart that its price action had recouped all its loss from the 2007–2009 crash and that the price was running into resistance, technically described as a double top. This, by itself, was enough to attract me to consider placing an option trade on it, so I looked deeper into it. After pulling up first the weekly, and then the daily on which I noticed a head and shoulder formation, I observed that there was a broken neckline of the head and shoulders. Self-evidently this was a bearish trade, yet I still needed to check a couple of other things: Fundamentals and the implied volatility.

When checking the stock fundamentals, I usually focus on three things: Quarterly earnings release date, dividend pay outs, and possible stock splits. None of these three were about to happen. Next, I checked the implied volatility of the underlying by going to the CBOE website, and looking it up in the "Volatility Finder – New" under the "Tools" tab. Surprisingly, the IV index mean was in the upper mid-range. Official Online Trading Academy teaching is to be a seller of premium while the volatility is high because then the premium is overpriced, and to be a buyer of debit spreads when the premium is in the lower range. In the mid-range, in between the extreme high or low, various other option strategies could be performed such as butterflies and ratio spreads.

Having looked at the fundamentals, technicals, and the implied volatility, I then proceeded to the option chain. Knowing that the volatility was in the upper mid-range means that the option premium will be somewhat expensive, or as I call it "fairly juicy."

Figure 1

Figure 1 has the listed options on the underlying for the months that are involved in this trade. At the time, the underlying was sitting at $45.17 so I was looking at selling the February vertical OTM call spread. Observe on the option chain above that the very first vertical 45/47.50 call spread would give us a credit of one dollar. Note that the issue would have to drop $0.17 before the 45 call becomes OTM. This would qualify this trade as moderately bearish.

The specifics of a 45/47.50 vertical call follow: Selling to open the Feb 45 call, and then buying to open the Feb 47.50 call for protection. In other words, I place a limit order for a credit of $1.00 and wait to see if I get filled, which I did. After I get filled, then I proceed to purchasing the next portion of my trade.

My outlook on this trade was extremely Bearish, the neckline of the head and shoulders had been broken. The distance between its head and the neckline was 3 points, so I see my target 3 points lower ($45-$3) at $42. My stop is above the high of the previous daily bar, at $45.35.

For the second portion of my trade, I am looking at buying an ATM April 45 put for $2.75. In order to finance that put of 2.75, I need to sell at least 3 vertical 45/47.50 calls for the $1.00 credit. Figure 2 below shows my market expectations for each of the contracts involved.

In order to make this crystal clear, I have created another chart to show which strike prices and which expiration months are involved in this trade.

As can be seen in Figure 3, if at February expiry the underlying closes and stays below 45, the sold 45 call would expire worthless as well as the long 47.50 call, and then I would be able to keep all of the maximum profit of the vertical 45/47.50 call spread. These 3 contracts of a short vertical call would be more than enough to finance my purchase of the long April 45 put, leaving me some change. For my April 45 put, I have presented a target at $42 and at the time of this writing, my position is within pennies of my target. By the way, just because I bought the April 45 put does not mean that I intend to keep that position until April. I am out when it hits my target. I might be in and out of it within a week or so.

Once the target is hit and I am out of the directional put position for profit, I still have the vertical 45/47.50 Bear Call on. Now I have two choices; (1) to wait for February expiry; or (2) to buy back my short 45 call. At the target of $42, my long 47.50 call is basically worthless and there is no point in selling it. Which one I will take only time will tell, yet the choices are there.

In conclusion, I have shown an example of creative financing. I have used the credit received from selling a vertical spread to finance the purchase of long directional premium. For those interested in learning more about this type of trade, I suggest re-reading one of my previous article on that topic, Some Kind of Colorful Options. When trading options use your creative side, and once in the trade, pay attention to what is going on with the underlying. I was double bearish in this trade and if the trade had gone against me, I would have then been double wrong. Hence, have your exits pre-planned, both for a profit or for a small loss. Have green trading.

- Josip Causic