Lawrence McMillan continues with VLO.
To recap - you were bullish on Valero. You decided to go with a long call spread, but now you are more bullish than previously thought. What's a trader to do? One choice is to "roll up." "Up" refers to the combination of buying back the original short strike and shorting a higher strike.
ROOKIE'S CORNER: Long Call Spread - The Options Playbook - Play #13
TRADE FORMATION - Part 1
On May 19th the trader bought VLO June 50 calls (Strike A) at a price of 2.30 and sold VLO June 52.50 calls (Strike B) at a price of 1.25. The same day VLO stock closed at $49.65 which is close to where you usually want the stock when entering this trade. This is a bullish trade with an upside target (Strike B or higher) and is an alternative to buying long calls outright.
Although the width of the strikes chosen can vary, they seem a little tight here (50 and 52.50). The month chosen (June) gives the stock some time to make a move without giving going too far out. The break-even point at expiration is 51.05 (Strike A plus spread debit). The sweet spot is the upside target of 52.50 or higher. The most you can make on this trade is 1.45 (Strike B - Strike A - spread debit). The most you can lose is the spread debit of 1.05 (2.30 - 1.25). The trader is risking less than s/he hopes to make, which is positive, but usually a favorable reward to risk ratio is usually coupled with a lower probability of success.
TRADE FORMATION - Part 2
On June 2nd the trader rolled the short strike. The June 52.50 call was bought to close for 1.50 - a loss of 25 cents. The June 55 call was sold for 83 cents (new Strike B). The new spread position is now long VLO June 50 calls (Strike A) and short VLO June 55 calls (Strike B). The cost incurred for all trades (without commissions) is 2.30 - 1.25 + 1.50 - 0.83 = 1.72 debit.
Click here for a larger image.
This new spread has wider strikes and a higher target price of 55 (Strike B). The benefits - a higher target strike gives more room for the stock to increase; a higher spread delta allows for higher profit potential as the stock increases; the maximum gain is higher at 3.28. The drawbacks - wider spreads put more capital at risk than narrower spreads; a larger delta also increases the loss potential when the stock decreases; the maximum loss is higher at 1.72.
FIELD CONDITIONS - the trading environment
Remember that the most important part of this play is the location of the stock in relation to 50 (Strike A). Because the strikes have been widened, the delta of the spread has been increased. The larger the delta, the more important the location of the stock becomes.
ALL-STAR COMMENTARY - by Lawrence McMillan
In the initial trade, the trader established a bull spread in VLO:
Bot 2 VLO June 50 calls @ 2.30
Sold 2 VLO June 52.5 calls @ 1.25
(he paid 1.05 debit)
My conclusion was that a bull spread was not really necessary - that an outright purchase of calls would have been a better alternative. However, one of my points was that, if you are going to use a bull spread, then at least widen the strikes out far enough to provide some upside profit potential in the short term. That is, get a good deal of long delta into the position.
So, with this adjustment, the trader has "rolled" the short side of the spread up from 52.50 to 55.00. He paid a debit of 0.67 to do so. Now, he has a total of 1.72 debit invested in the position. This adjustment certainly helps some. First of all, the delta of the position has increased:
Option Call Price Delta (6/2)
VLO June 50 call 3.55 0.76
VLO June 52.5 call 2.00 0.55
VLO June 55 call 0.96 0.35
Position Delta
VLO June 50-52.50 call spread 0.21
VLO June 50-55 call spread 0.41
So, per spread, the delta was 0.21 (0.76 minus 0.55) and now it is 0.41 (0.76 minus 0.35).
But, I still have a problem with using a bull spread where one is not needed. Recall, that in the previous blog, I noted that, for a bull spread to be useful, there needs to be an "edge" in the spread. Typically there is an edge if the options are overly expensive; for, in that case, it makes sense to hedge the purchase of an expensive call (the one with the lower strike) with the sale of an expensive out-of-the-money call. And, preferably, the call that is sold is well out of the money, so that the position has a healthy long delta.
These VLO options do not meet those criteria. At least these are short-term options, so that there is some widening of the spread when the stock rises. If one were to establish a bull spread with no edge, using longer-term options, it might not widen much at all, even if the underlying rises in price.
Consider the following profits:
Strategy Initial Price Current Price Profit % Gain
Outright long VLO June 50 call 2.30 3.55 1.25 54%
June 50-52.5 bull spread 1.05 1.55 0.50 48%
June 50-55 bull spread 1.70 2.59 0.89 52%
You can see that the bull spread with the least distance between the strikes produced the least dollar profit and the smallest percent gain. Furthermore, this situation only worsens if the stock really starts to rise quickly, since the gains would be limited in the case of the spreads, but are virtually unlimited in the case of an outright long call.
Click here for a larger image.
In summary, while it is an improvement to widen the distance between the strikes, I still prefer the outright long call purchase in this case where the options are not overly expensive.
President
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This comment and any market data included here were prepared on 6/2/08.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Lawrence G. McMillan has a professional business relationship with TradeKing.