Creative Financing with Options

04/26/2010 10:50 am EST


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, and 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 payouts, 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 Web site 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."

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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 are as follows: Sell to open the February 45 call, and then buy to open the February 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.

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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 three points, so I see my target three 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 three vertical 45/47.50 calls for the $1.00 credit. The figure below shows my market expectations for each of the contracts involved.

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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.

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As can be seen in the above figure, 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 three 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) Wait for February expiry; or (2) 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 choose 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.  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.

By Josip Causic, instructor,

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