Saturday, April 26, 2008

Outright Options vs Debit Spreads

Selecting a strategy for that next option trade can be a difficult choice. This example will focus on Semiconductor HOLDRS Trust (SMH). I am bullish on SMH in the long-term and I'm trying to decide whether I want to buy outright calls or do a debit spread.

Start with the chart. I think SMH bottomed on Jan 22 and is grinding its way back up.

If it breaches the trendline I have drawn I will abandon the trade and cut my losses; otherwise, I think it will keep following this trend upward. I think it has the potential to retest 35.50.

Expiration. Since I'm leaning toward buying options on SMH I want to give myself a few extra months. I'm picking Nov 08 as my time frame even though I have no intention of holding onto the calls until then.

ITM, ATM, OTM. This again has a lot to do with your strategy and expectations. In this example, I'm moderately bullish. Since I'm only moderately bullish I would avoid deep ITM calls since they are quite expensive. DITM calls can be a great way to go if you are extremely bullish since they are composed almost entirely of intrinsic value, plus its delta will be close to 1. DITM debit spreads don't work well from a risk/reward perspective. This leaves me choosing between ATM and OTM. Since I don't expect an explosive move out of SMH, I'm probably okay with one strike OTM calls.

Option Pricing. There are two easy ways to determine whether the options you are looking at are cheap or expensive. First, you can check the actual option price against its theoretical price by using an option pricing model such as Black-Scholes. Second, you can look at the options implied volatility (IV) relative to its historic range of implied volatilities. When implied volatility is high, look for selling strategies and when it's low consider buying strategies. Most online brokerages will provide these tools. In this screenshot you can see that SMH's IV is about in the middle of it's 1 year range and near the bottom of its 3 month range.

This first screenshot shows both historical and implied volatility for the last 12 months and the second screenshot shows an option chain and option pricer from OptionsXpress. The red arrow gives the IV, the green arrow is indicating the expiration month, and the blue arrow points to theoretical values determined by the Black-Scholes model.

Trade Calculator. I use a trade calculator provided by OptionsXpress but again, most online brokers offer similar tools. The tool is great for analyzing and comparing different strategies. I'm going to now compare some risk/reward ratios and their breakeven points. First, let's assume you're willing to risk about $1,000 for this trade and would like to see a return of 2:1.

Strategy 1: Buy 5 of the NOV 32 Calls.
Risk: $1,075
Reward: Unlimited (since SMH isn't likely to go to infinity by November let's realistically say that the potential reward is $1,000 - which roughly correlates to the stock being at 35.50 at expiration)
Breakeven: 34.15

Strategy 2: Buy 10 of the NOV 32 Calls.
Sell 10 of the NOV 35 Calls.
Risk: $1,100
Reward: $1,900
Breakeven: 33.10

You can see that Strategy 2 looks like a better choice. The breakeven point is lower, the risk is about the same, and the realistic reward is higher. If my price target had been 40 I would be tempted to purchase the calls outright, but 35 is a more realistic target so it makes sense to finance the purchase of the calls by selling some deeper OTM calls. Defining price targets is very important in choosing a strategy. The thought of 'unlimited reward' is always exciting but rarely realistic.

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