Tuesday, January 27, 2009

Above the RIMM

Today I want to highlight a bull call spread strategy using RIMM. Recently RIMM has exhibited relative strength vs. the broader market and vs. the technology sector.

The bull call spread is considered a vertical debit spread. It is constructed by buying a lower strike call option and simultaneously selling a higher strike call option of the same month. The credit received from selling the higher strike call helps partially finance the cost of the long option, thereby reducing the overall cost and risk of the trade. Furthermore, by being both long and short call options, it helps mitigate the volatility and time decay risk-

Let’s look at an example:

RIMM @ $51
Buy March 55 call for $3.50
Sell March 60 call for $1.50
Net Debit = $2.00
Max Risk = $2.00
Max Reward = $3.00
ROI = $3.00 / $2.00 = 150% return

As the risk graph portrays, to capture our maximum reward we need for the stock to be above the higher strike price ($60). If at expiration the stock is below the lower strike price ($55), both calls expire worthless and we lose our entire net debit.
There are multiple ways to manage this bad boy & I'm interested in your thoughts.....
Namely, what's a typical target, stop loss, or perhaps adjustment technique for this type of spread?


dustin gedney said...

Pretty new to trading and this post is obviously pretty old. It's now Sept. 10th, 2010 and this has been my first quarter of trading. It has also been the worst quarter in the market over the last 9 years. That being said I now know to use tight stops. I'd say to set a stop-loss to where you'd risk 5-10%. If the trade doesn't do what you want it to immediately move on or exit it and try again.

What I didn't really contemplate with call spreads is the time value. Let's say RIMM, closes above the strike that you sold the very next day after you put on the trade. You don't reach or even come close to you max. profit do you because the trade still has time left before expiration. This seems to be the case which says to me the gain you would have would be so dismal you might as-well let the trade go on for a few weeks if its a front month contract, in order for time value to decrease. Im not the expert though so you tell me...

It seems as though if I'm looking to day trade/swing trade then call options are really my best choice rather then spreads because my profit would look much better over just a day or two on the trade.

Tyler Craig said...

Hey Dustin,

Glad to have you stop by the blog. There's quite a bit of option related content on here that should help you to better grasp their dynamics.

Some type of stop loss or exit strategy is a must in my book. My approach tends to vary depending on the strategy I use. So as opposed to using some arbitrary number like 5-10%, I tend to choose my stop placement based off of key support/resistance levels.

As to your question on the call spread, I'll go ahead and give you an extended answer in my next blog post. Probably tomorrow.