As long time readers know, I prefer selling option premium to owning it. But that is not for everyone. Today I respond to questions from a trader who typically owns options.
I would be grateful if you could share your experience and answer a few general questions for me:
1) Do you see any benefits of using long calls rather than bull call spreads if one uses sell limit orders, thus capping one’s upside from the outset anyway?
2) When swing trading with the use of monthly options, would you normally recommend closing one’s positions no later than on Friday preceding the expiration week, or do you sometimes see some merit in holding them into the expiration week?
3) When one does not intend to hold one’s position into earnings but wants to capitalize on the pre-earnings volatility rise, do you – other things being equal – recommend closing one’s positions immediately prior to earnings or a few days earlier? Does your experience suggest that there is some general rule as to when volatility rises the most?
4) What, in your opinion, is the maximum percent of one’s portfolio that can be safely committed to options positions? Is it around 15-20% or more/less?
Thank you in advance for your help.
1) When comparing the strategies of owning calls (with the potential for unlimited gains) vs. owning call spreads (with a higher win/loss ratio and reduced cost — but with limited gains) in my opinion the most important factor is your expectations for the trade. Obviously if you expect to see a huge price increase in the underlying asset, you will buy calls and not spreads. [Caution: Sometimes the stock moves far less than expected, so please do not buy out-of-the-money calls.] If you anticipate the stock price to increase, but you do not have any idea how far, then you want the lower-cost position as well as the position that is more likely to provide a profit. That means buying the call spread. Remember that the call spread can return a profit even when the stock price is unchanged (assuming you buy an ITM option and sell an ATM or OTM).
To answer your specific question: Yes, there are small advantages to owning calls in the scenario you describe. If you want to exit the trade and take your profit (at your limit price), you may be dissatisfied with how much you can collect when selling the call spread. In other words, you may not be able to exit without accepting less than you think the spread is worth. That is always a risk when trading spreads. It is always easier to sell your single call option when it reaches your target price.
However, I still prefer spreads. I must ask this: How good is your track record? If you are skilled at picking stock direction and if you are skilled at timing the trade, then you have a huge edge over almost everyone else. With that skill-set, you can afford to buy single options. However,it is most likely you don’t have an outstanding record and that translates into trading positions that give you the best chance of earning a profit. That is the call spread. [Side note: You may prefer to sell put spreads instead. If you are not familiar with this concept, you can read about it and decide later. When the strike prices and expiration date are identical, selling put spreads is an equivalent strategy and produces the same profit/loss as buying the call spread.
2) Swing trading is for traders with a specific price target in mind for the underlying stock. Let’s assume that you own calls and want to continue to own calls as expiration nears.Then the true way to look at this problem is: How much does it cost to roll the position out to the next month. In other words, what does it cost to buy the same strike (as you own now) calendar spread? You know that your long option is going to decay rapidly over the final week, unless your stock QUICKLY performs as expected. So most of the time it is better to buy the calendar spread now than it will be to buy it next week. Unless you get the price change needed. I prefer to roll in this situation, knowing that the timing of my expected rally is unknown. The swing trader has a price target but not a time target. Thus, you do not know when the stock will move to your target. That means it provides a better average result — over the longer term — to roll as necessary to minimize the cost of owning options. If you accept that opinion, then Friday, one week prior to expiration is about as long as you should hold the current position.
3) Immediately prior. Although not all stocks act the same, the vast majority of options show a rising volatility on the last day of trading – prior to the news announcement. That is not 100% true, but as a general rule, I would sell options on that last day. HOWEVER: Do not get blinded. If the price increases and you can lock in target profit earlier than that date, take your gains because it does not pay to get greedy.
4) That must vary from trader to trader. If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options. If you are skilled — if you make money via this strategy — and here is a tough one: if you are really a good predictor rather than being a trader who is making money just because it is a bull market — then by all mans, you can afford to invest more than 10%. But understand that bull markets end and if you have little or no experience with buying puts and put spreads, then by definition you will enter hard times if and when this bull market ever comes to an end. Please consider that. I have seen too many traders ride for years with a single strategy, only to lose a ton of money when the market behaved differently.