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.
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 own opinions about who makes a good life partner, two traders can look at the same stock and see different 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.
Getting To Know You
If your first decision is about what you’re going to trade, your second decision concerns how. From the start, understanding strategy mechanics will help you match trading decisions 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 (DTE), trading at $0.99, with a long 134/136 call vertical with 45 DTE, 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 DTE 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 DTE 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 OTM; 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 quickly.
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 smooth sailing.
The First Fight
The difference between the theoretical values of a short- and long-term vertical depends on how likely they are to be ITM at expiration. At expiration, a vertical will be worth zero if it’s OTM. If both options are ITM, the vertical will be worth its full value of the difference between the strikes. And if the stock is in between the strikes of the vertical, it’ll be worth the intrinsic value of the long ITM option. If you’re long a vertical, you’ll potentially realize the most profit if both options are ITM at expiration.
The likelihood that a vertical is ITM at expiration depends on where the stock’s price is in relation to the vertical’s strikes and time to expiration. For the 134/136 call vertical with one DTE with the stock price at $136, it’s ITM. And the likelihood that the stock will stay at $136 or above over the next day is fairly high. Over those 39 days, there’s a chance the stock could drop back down from $136 to $134 or below, to make that 134/136 call vertical OTM. That’s why the 134/136 call vertical with one DTE has a higher theoretical price with the stock at $136 than the vertical with 39 days to expiration.
Alternatively, with the stock at $134, it’s less likely the stock will rally to $136 in one day versus 39 days. It’s not impossible, it’s just not as likely. That’s why the 134/136 call vertical with 39 DTE has a higher theoretical price with the stock at $134 than the vertical with one day to expiration.
Think of it this way: in most cases, the maximum value a vertical can theoretically get to is the difference between its strikes, which happens if both options of the vertical are ITM at expiration. Before expiration, an ITM vertical will usually trade under its full value, because with some time remaining until expiration, there’s a chance the stock price could change and turn that ITM vertical into an OTM vertical. The more time to expiration, the more time the stock has to do that. With less time to expiration, there’s less time for the stock to move to a price that would make the vertical OTM.
The opposite is true for OTM verticals. With less time to expiration, there’s less chance for the stock to move enough to make that OTM vertical ITM. With more time, there’s more of a chance. The prices of verticals, then, reflect the likelihood of them being ITM or OTM at expiration, with OTM verticals with more time to expiration having higher theoretical values than OTM verticals with less time to expiration, all things being equal.
Time To Move On
It makes sense to match the expiration of the options to your opinion of when a stock might move. Many stocks now have weekly expiration options, in addition to standard expirations (see Figure 1)*. This lets you tailor a strategy to match your risk tolerance by choosing certain strikes, while matching your market expectation by choosing a certain duration for a trade.
As always, consider the information at hand. Are earnings coming up in a few days? Is the Fed making an announcement the following week? Is there a significant election in the months ahead that might call for speculation? Gather up the data. Find an expiration that comes close to these collective events, then match your interest to a reasonable level of commitment. Above all, analyze with clarity and trust your instincts. And don’t tell the wrong jokes when you finally meet the parents.