Friday, September 3, 2010

Call Spread Conversations

I received a question regarding call spreads in response to last year's Above the RIMM post. Since I've heard variations of the same question over the years, I thought it might be beneficial to outline my response in today's post.

...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.

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...

You're pretty much on track regarding how long call spreads progress. Since reaching their maximum value requires all of the extrinsic (time) value to bleed out of the option, you either have to wait until expiration or have the call spread move deep enough in-the-money until the calls are trading close to parity. So, while it's not impossible to capture the bulk of your rewards in just a few days, it's rare. If you desired to accelerate the progress of a call spread, you could simply use shorter dated options versus longer. For example, if you purchased a one month call spread versus three months and the underlying stock moved through the spread, the front month spread would rack up gains quicker.

Now, as to whether the gains will be "dismal" really depends on the magnitude of the move in the underlying stock, which expiration month you're looking at, and how many contracts you have in the position. Suffice it to say, long call spreads are not the most efficient, nor effective way to exploit short term moves in a stock. So, in that regards we are in agreement.

However, just because a long call spread isn't the most effective vehicle doesn't necessarily mean that buying call options is the "best choice" for day/swing trades. Honestly it's difficult for anyone to say what is or isn't the "best choice" as it varies from trader to trader depending upon what you're trying to accomplish. Due to the inherent trade-offs which all the option strategies the "best choice" will inevitably vary from situation to situation. If your goal was to swing for the fence by accumulating a high delta position, then I can see the allure of trading call options. Just keep in mind, they can be quite unforgiving when you're wrong.

Though purchasing call options is much more effective than call spreads when day trading, I think there are superior alternatives in the day trading arena. Since day traders are playing smaller moves in a stock, they need higher delta positions that rack up profits quick. In that regard, futures and stock are more effective. The other issue that arises with options is the wider bid/ask spread. While that may not present much of an issue if you're doing a longer term trade, it can create a large problem when day trading because you're typically playing very small moves in the stock.

For related content, readers can check out:
Call vs. Put Spreads
Call Spreads and Assignment

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