While last year was a great year for buying call options and rolling them over month after month, the days of simply buying calls came to a hard stop at the end of December. This year has been much more volatile with a host of concerns ranging from the war in Ukraine to a much more aggressive Fed. Currently we are in a whipsaw environment with very little trend, and the recent moves from the major indices are a sign of how uncertain things are in the present moment.
After essentially tumbling into a bear market to kick off the year, the Nasdaq shot up over 16% from its year-to-date low only to flip and drop back below the 200-day moving average. This key technical point serves as a trigger for a host of algorithms that drive the massive automated trading systems controlling the majority of the markets. The time to shift to a strategy that outperforms in swingy, volatile markets is now.
Before we examine today’s trade, let’s review some basics. There is no need to worry about complex mathematical formulas or equations. My mantra when it comes to option investing is ‘keep it simple’. Over the years I’ve found that the more complicated a strategy is, the less likely it will work over the long-term. We want to employ a strategy that has a history of profitability and is easy to follow.
Options are standardized contracts that give the buyer the right to buy (calls) or sell (puts) the underlying stock at a fixed price which is known as the ‘strike price’. These contracts are valid for a specific period of time which ends on option expiration day.
Below we’re going to explore a call option spread strategy. Buying a call option (bullish) is similar to buying a stock in that the goal is to sell it at a higher price than you paid. Shorting a call option (bearish) is similar to shorting a stock as the goal is to buy it back at a lower price to realize a profit.
The Power of Option Spreads
If the first quarter of the year was any indication, we can expect to see a swingy 2022 as the back-and-forth environment looks set to continue. Being able to adapt to the market environment is what separates the good traders from the great ones. Applying the right strategy that will outperform during this type of market is paramount to our success.
Spreads are extremely effective when markets get range-bound. Option debit spreads are implemented by purchasing a call option and selling a related call option with a higher strike price. These types of trades are limited risk trades because the short option is ‘covered’ by the option purchase. When done correctly, trading options provides huge profit opportunities with limited risk making options one of the most versatile investment vehicles.
Let’s take a look at an example in this current market environment.
The Trade – PANW Debit Spread
Palo Alto Networks PANW currently meets our criteria for initiating a bullish option spread position. A Zacks Rank #3 stock, PANW is trending well and is outperforming the market this year. The stock is part of the Zacks Security industry group, which ranks in the top 42% out of approximately 250 industries. PANW has exceeded earnings estimates in each quarter for the past five years running. The stock is hitting a series of 52-week highs on increasing volume.
We can see below the details of this spread trade. PANW is trading at $624.07/share at the time of this writing. This trade entails purchasing the May 540-strike call at 93.25 points, and selling the May 580-strike call at 61.75 points for a total cost of 31.5 points. As option contracts represent 100 shares of the underlying security, this would represent a total cost of $3,150 per contract.
Image Source: Zacks Investment Research
Pay attention to the third section of the above image. The first and last lines of this section are the most important. Notice that the first line dictates the underlying price movement of PANW stock, ranging from a -7.5% decline to a +7.5% gain. The last line in this section shows the return of the option spread trade.
If PANW declines -7.5% by option expiration (highlighted in red), this trade will profit $576, an +18.3% return. If PANW declines by 5% or less (or remains flat as highlighted in blue) this trade will realize an $850 profit or +27% return in just over a month. These are types of odds I like to have in my favor when trading options.
Advantages of Spread Trading
1) The Option Sale Provides Downside Protection
The sale of a call option results in cash being credited to your brokerage account. This reduces the cost basis of the option purchase and provides downside protection in the event the price of the underlying stock declines.
2) Risk is Reduced
In the PANW trade just presented, the sale of the 580-strike call reduced the risk of the 540-strike purchase from $9,325 to $3,150 per contract.
3) Allows Us to Maintain Positions During Volatile Markets
The downside protection provided by the call option sale helps us maintain our spread trade during heightened volatility. Naked option purchases may force us to sell early in order to prevent large losses.
4) Spreads Can Be Profitable If Stock Goes Up or Down
Option spreads can be profitable even if the underlying stock decreases or remains flat, providing us with an entirely new dimension of money-making opportunities.
The call option spread strategy is an excellent way to profit during periods of high market volatility. As of April 12th, the S&P 500 Index is down -6.68% year-to-date. Despite the recent volatility this spread strategy has been performing well. Remember that the call option sold through this strategy profits as the price of the underlying stock declines, providing us with a cushion during market pullbacks.
Option spreads are a safe way to use the leverage inherent in options. Your risk is limited to the price paid for the spread. Volatile markets don’t have to be scary; instead, they can present a great opportunity to profit. I think the preceding trade example demonstrates why option spreads are an ideal investment!
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report