- 1999: Volume 8, No. 5 Using the Right Option Strategy

Stock option premiums are reasonable despite the recent correction. (Often, a sell-off leads to more expensive options.) So buying calls would be a feasible way of playing tech stocks for a rally. Also viable are other bullish strategies such as a vertical debit spread in calls or a backspread in calls.

How do these strategies compare, and how should the individual trader select the best for himself?

Each strategy has its own unique risk/reward characteristics. The individual trader must choose the strategy that matches their own trading philosophy and psychology.

A simple call purchase is like raw energy. This position responds dramatically to every move in the underlying. And if the underlying has already moved your way to a certain extent, the call option, now more expensive, gains or loses even more money with every move in its underlying. (In options parlance, the option's delta or sensitivity to the underlying has become greater.)

This is where trouble can arise. Increased stress on the trader, now trying to pick an appropriate selling point, may contribute to a bad decision. For example, a sudden (but not great) drop in the underlying can lower the price of the option and cause the trader remorse that he did not sell earlier. Now he must decide whether to sell and lock in whatever gain he has before the stock drops any further. On the other hand, a sudden rise in the stock can easily double the value of the call option, possibly leading the trader to feel euphoric and smug, emotions just as dangerous to successful trading as anxiety!

It must be a strong, disciplined trader who gets into a simple call purchase. The trader, realizing what kind of (raw) position he's gotten himself into, adds his own discipline-an objective, stop, and perhaps a trailing stop.

For the more casual trader, milder positions can be found among the various types of spreads.

For example, a vertical debit spread (in calls) is a position formed by the purchase of one call option and the sale of another call option in the same expiration but at a higher strike. Since the call purchased has a higher price than the call sold, this position costs you the difference, and thus is called a "debit spread."

Such a spread responds to the underlying by "widening" as the underlying goes up. Thus it is a bullish trade.

For another example, a backspread (in calls) is a position formed by the sale of one call option and the purchase of two other call options in the same expiration but at a higher strike. Although this strategy sounds complicated, there is method behind the madness. The calls sold, being closer-to-the-money and more expensive, substantially "pay for" the calls purchased. And although these short calls work against you as the underlying moves up, the fact that you bought two times as many calls as you sold, and are thus net long calls, causes this to be a bullish trade overall.

Both types of spreads-all spreads for that matter-allow the trader more time to make an exit decision. You may even hold a spread all the way to expiration without concern over rapid time decay.

Consider the Hewlett Packard price chart in Figure 1 and a reasonable bullish price projection to the end of August. (The rectangle represents our projection.)

Figure 1

For the same money ($5,000), in Figure 2 we have analyzed and superimposed the performance of three strategies: 1) a simple call purchase; 2) a vertical debit spread in calls; and 3) a backspread in calls. Each position was picked as having the best expected return in its strategy class based on our projection for the underlying.

Figure 2

Each position has a different profile. The simple call purchase has the best overall expected return this time. (Note that this is not always the case. Depending on the investment timeframe and the current volatility scenario-how expensive the options are from a historical context-the spread can have better expected returns than simple call purchases.)

The flattest, most sedate line belongs to the backspread. Note that this strategy performs much better than the others if the trader is wrong and no rally materializes. Thus the backspread is the most conservative strategy.

The final strategy-the vertical debit spread-has a line very close to that of the simple call purchase except that as the underlying goes up, the spread's performance is steady and straight, while the call purchase's line curves ever upward. In other words, the spread's delta remains constant in this area, while the call purchase's delta continues to increase. This translates into less stress for the spread trader. Thus the vertical debit spread is more conservative than the simple call purchase, but more aggressive than the backspread.

(By the way, all three of these strategies perform better than simply buying shares of the underlying stock-much better.)

So you're trying to pick the right strategy to play an expected rally? Select the strategy that best matches your profile. A lot depends on how involved you want to be, or can afford to be, in watching the markets. Your trades need to be interesting but not anxiety producing. If you go for an aggressive strategy and then find yourself becoming too emotionally involved, you may need to consider scaling down. Successful traders are unemotional, unstressed traders.

Len Yates is the President of OptionVue Systems International. which has been producing award-winning software for over 16 years. OptionVue Systems International offers a family of products and services centered around OptionVue 5ª, the most powerful options analysis software ever developed.

For more information on OptionVue 5 and the other products and services offered by OptionVue Systems International, visit www.optionvue.com or call (800)733-6610.