Intro to Alternative Option Trading
- Written by Carley Garner
Bull Call Spread with a Naked Leg
Buy Call A
Sell Call B (higher strike price)
Sell Put C
When to Use
- You think the market will go up, but purchasing a near-the-money outright call option position is very expensive
- The goal is to produce a very inexpensive, or even free trade. A free trade occurs when you collect enough premium on the short legs of the spread to overcome most or all of the premium paid for the long legs. Keep in mind that the term free does not imply that there are no transactions costs, margin, or risk.
- Profit is limited to the difference between the strike prices of the long and short call plus a net premium collected if executed as a credit
- At expiration the breakeven is equal to the long call strike price plus the net amount paid for the spread plus the transaction costs paid if executed as a debit
- BE = Long Strike Price + Net Premium Paid (if a debit) + Commissions and Fees
- RBE = Short Put Strike Price - Net Premium Collected (if a credit) + Commissions and Fees
What is the Risk?
- Risk on the downside (short put) is theoretically unlimited
- The market trading below the short put is equal to being long the futures from the put strike price
- At expiration if the market is between the short put and long call you lose the net paid for the spread if it was executed at a debit. If it was executed as a credit, the trader keeps the premium collected
Perhaps the bull call spread with a naked leg is best used in a situation in which going long a futures contract could be considered to be an attempt at "catching a falling knife". In other words, if you are interested in a counter trend trade this may be the most efficient way to aggressively play the market. This is simply because the trade involves a long call in combination with a short call and a short put. If the futures market is trading wildly lower, you may be able to get the long call at a reduced price and collect top dollar for the short put.
Looking at Figure 3, you can see that in late July the bond market had made a swift down move and was approaching the 1st level of pivot support. A trader without regard to risk management may simply buy a futures contract and hope for the best but a savvy trader may use a bull call spread. Doing so allows him to gain exposure to the market without jumping in front of the bus.
One version of a bull call spread with a naked leg would be to buy the September Treasury Bond 114 call and pay for it by selling the 116 call and the 112 put. Based on the theoretical values available to us, it may have been possible to execute the spread for a net credit of $15.63 before considering commissions and fees. The net credit is the result of collecting more premium for the short options than is paid for the long. Simply put, the market would have paid you a little over $15 to do this trade making the trade essentially free to execute. Please note that while this trade is 'free' in terms of out of pocket expense it still involves transaction costs, margin and unlimited risk below 112.
The maximum profit is equal to the distance between the long call and the short call plus the net credit and minus transaction costs and occurs if the futures price is above 116 at expiration. In this case it would be a little over $2,000 before commissions and fees.
The margin required on a trade like this varies and is based on an exchange owned software package known as SPAN (Standard Portfolio Analysis of Risk). However, given the distance from the market the margin on a trade like this is estimated to be about $1,000. Keep in mind that the margin can increase to an equivalent of the futures contract. This will typically occur if the futures price drops against the short put option.
Carley Garner is an experienced futures and options broker with DeCarley Trading, a division of Zaner, in Las Vegas, Nevada. She is also the author of "Currency Trading in the FOREX and Futures Markets", "A Trader's First Book on Commodities" and “Commodity Options” published by FT Press, a division of Prentice Hall. She has also contributed to the FT Press Delivers line of digital products, "Insights for the Agile Investor". Her e-newsletters, The DeCarley Perspective, and the Financial Futures Report, have garnered a loyal following; she is also proactive in providing free trading education.
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