How to Trade Bear Call and Bull Call Option Strategies

05/13/2010 12:01 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

In my previous articles, I have given examples of my trades, yet many of the readers did not understand the basic, inner workings of the actual option strategy. Options are derivatives and their inner workings are impossible to explain in a thousand-word article. Therefore, I have proceeded to explain them by writing a series of five articles on the specific strategies, such as butterflies and verticals. Yet, even after the completion of that series of articles, many things are left unsaid and unspecified.

Here, in this article, I will focus on the implementation of the strategy, as well as on the comparison. Namely, I will use one of each of the verticals: A short vertical and a long vertical so the similarities and differences can be easily observed. For simplicity's sake, I will stick to the same option class, in this case, to the call side. The verticals that I will be addressing are also known as a bear call and bull call.

Bull Call Part

The long bull vertical (or bull call) is used when the implied volatility is low or near its lower range. The technical analysis on the chart should present us with a situation in which the underlying asset is bouncing off the support and heading higher. Just because we are trading a spread trade does not mean that no stop losses are needed. Keep in mind how much it would cost to close that spread for a loss versus the risk/reward ratio. Besides checking the IV (implied volatility) and the TA (technical analysis) of the underlying, we also need to check the bigger picture, such as the broad market. The ideal goal is to trade the optionable stocks in the trend of the overall broad market, and the trend of their respective sectors as well as their specific industry groups. For instance, if one is considering placing a trade on Citigroup (C), he or she should check the trend of the overall financial sector and the specific industry (money center banks) that Citigroup is in. This approach applies for trades that are in the bullish trend or the bearish inclination.

I am addressing the bull call spread (long bull vertical) and if I am truly bullish on Citigroup, what I would like to ideally see is that the broad market is in an uptrend, as well as the financials and money center banks. Ironically, the broad market was in an uptrend as of the writing of this article.

Besides checking the TA (on the stock, industry, sector, and broad market) and the IV of the underlying asset, the VIX (broad market's volatility index) must be checked as well. Once those components are checked, an option trader could proceed with the selection of the strike prices and the month of expiry. At Online Trading Academy, we option instructors tend to keep things simple. If we are the buyers of options, as we are in the case of the long bull vertical (bull call), we need to buy the options that are expiring 90 days or more from now. (As the sellers, we like to sell the options that are expiring in 60 days or less.)

For the strike selection, the chart needs to be consulted and the areas of the supply and demand must be properly identified. For instance, if XYZ is trading around $114.50 and we see that the support (demand zone of the buyers) is around $113, then we could select the strike price of $111, which is slightly (ITM) in the money. In other words, technically speaking, the price came down to the 113 zone and bounced off it to $114.50 with the huge volume.

At the same time, if we observe on the chart that the resistance (supply zone of the sellers) is at or above $117, it makes sense then to sell the strike price of $117, which is basically (OTM) out of the money.

The spread would be composed of the following two legs:

The XYZ @ $114.50

BTO + 10 (far-out month) 113 (deep ITM) calls

STO – 10 (far-out month) 117 (deep OTM) calls

As the product goes up, the 113 call, which is already in the money, increases proportionately to its delta. In the meantime, the 117 call also increases in value proportionately to its delta. Yet keep in mind that the premium is composed of two parts: The intrinsic value and extrinsic value. If at the expiry, XYZ is closing at $116.50, then the 113 call has $3.50 of the intrinsic value, while the 117 call has none.

Bear Call Part

Next, let us move to the bear call (short bear vertical), which was my favorite strategy over the last three years. I have written many, many articles on it during that time.

In the case of the bear call requirements, I will simply compare them against the bull call requirements. Look at Figure 1 below:

chart
Click to Enlarge

The short vertical spread criterion is exactly opposite of the long vertical. The market outlooks are 100% different; one is the debit, the other is the credit-type trade. Implied volatility requirements are at the opposite side of the spectrum. The expirations are different, too. When something is sold, the seller wants to be released of the obligation in the shortest possible time. Lastly, the outcomes are also different. When something is bought, the buyer obviously likes to see the increase in the value.

In conclusion, I have compared a long vertical call spread with a short vertical. Besides giving a lot of written explanations, I have created a chart that visually shows the main difference of the two. Print it out, cut it out, and place it next to your trading computer.

Good luck and have green trading!

By Josip Causic, instructor, Online Trading Academy

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