Lessons from the Pros

Vertical Call or Vertical Put?

In my most recent class in Minneapolis, MN, I was working with a group of options students on finding a bearish trade. A specific product, which I will leave unnamed, simply jumped out at me right after looking at the chart. Figure 1 below shows the product which had reached its resistance at 30. Twice it failed to break above it, and the current candle at the top of the uptrend had created a shooting star, which even by itself showed a strong bearish bias.

Figure 1

Having selected the 30 level as the obvious area of resistance, my Minnesota students and I entertained the possibility of placing a vertical credit call. This strategy is also known as a Bear Call, thanks to Larry McMillan who named it. In the case of the Bear Call, we were considering buying an OTM (out-of-the-money) October 31 call and selling an ATM (at-the-money) October 30 call. The difference of the two premiums would produce a credit.

However, as I have shared in my previous article, Plan the Exit(s) Beforehand, I do have several steps that I usually go through. The first one involves looking at the Fundamentals of the product that I am considering. In our case, the product was scheduled to have its earnings release in early November, which is after October expiry. Hence, there should be a checkmark with a passing green light on my first criteria.

By the way, the earnings release had taken place in early August and it is obvious on the chart. Namely, the gap in August which separates the current price action from the previous action was caused by the earnings release. My gut feeling is that most likely, the gap is going to get filled at some point.

Anyhow, there were also neither dividends paid out on the horizon nor stock splits. Hence, this is a green light for my criteria. For those readers eager to find out all the steps, I suggest rereading my article mentioned above. Just click on the hyperlink which will take you right to the article that lists all the trading steps that I follow when I enter my positions regardless if they are long or short.

In the case of this unnamed product that I was considering, technical analysis, the second criteria on my list was telling me that I should sell a vertical call on it. However, after checking the implied volatility (I.V.) of the underlying, the third criteria on my list, I realized that the I.V. was in the lower range. At that point, I told my students that the teaching of Online Trading Academy is to sell high I.V. and buy low I.V. In other words, if the I.V. compared to itself is low, then we should be the buyers of options, but if the I.V. is high then we ought to be sellers. In our case, the underlying was sitting in the lower range, which I simply translated as the right opportunity to buy a debit spread. Hence, instead of entertaining the possibility of selling a Bear Call, the strategy which I advised doing when the I.V. is in the higher range, we did a different trade. We were still technically Bearish on the underlying yet we switched from vertical call selling (shorting the Bear Call) to vertical put buying (or going long on the Bear Put).

The specific action was still built around the 30 zone which was the area of resistance. Hence, we first purchased an ATM October 31 put @ 1.41, and then simultaneously sold an OTM October 30 put for 0.90 which created a debit of 0.51 cents. Next in order to calculate our Maximum Profit, we took the width of our spread (31 put minus 30 put), one point and subtracted from it 0.51 which was our debit/risk. The amount which we were left with was 0.49 cents (0.49 = 1.00 – 0.51). Our forecast for the product was bearish, and we anticipated the underlying to drop below 30 and that would make our trade profitable.

However, if the trade turned against us, the mathematical breakeven point (BEP) would be 30.49, meaning that this trade could even go against us 0.49 cents before we actually start losing additional money. In the scenario described above, the time (extrinsic) component is taken out of the equation.

The fourth criteria which I use involves proper position sizing. In the classroom, I always use a single lot, for options cannot be traded in any smaller increment than a single contract since each contract already controls a hundred shares.

The fifth criteria is entry and active monitoring; the key word being ACTIVE. If this product rips to the upside, then we have to unwind our position. Once again, we have a short 30 put and a long 31 put. What I would do if the price goes above 31, which is bullish, is to turn my Bear Put into a Bull Put. The specific action which I would take wouldn’t involve touching the existing short 30 put. Instead, I would close out my long October 31 put by selling to close (STC) and simultaneously, I would buy to open (BTO) the October 29 put. Consequently, I would end up with a short 30 put and a long 29 put. The forecast of that trade would be that the underlying would close above 30, which at the moment of my trade repair would already have gone above it.

The last and final step would be the exit, which ideally would mean that both of my options expire worthless. If the product closes at expiry at 32, then my 30 put as well as 29 put have no value and there are no exiting commissions to be paid.

In conclusion, I first walked my Minnesota students through my thinking process when placing a trade. We followed all the steps and as the trade evolved against us, I provided a repair strategy as soon as it was clear that the price was heading above our BEP of 30.49. Once again, I emphasized ACTIVE monitoring and management of our open position. I cannot overemphasize the importance of trading discipline and sticking to the trade plan. Have green trading.

- Josip Causic