A few weeks ago we wrote about a potential options play in Alcoa Corporation (AA). The position we discussed is known as a call vertical and it is a great way for an options trader to reduce their overall exposure in a position and create a setup with a well-defined reward to risk ratio. Here we will discuss the benefits of trading options spreads like this over outright options. Below is the trade setup from January 6th 2017 and you can read full analysis and trade setup HERE.
Trade Setup: With AA stock trading at $30.65
Buying the AA Jan 29-28 Put Spreads for $0.25
Risk: $25 per 1 lot
Reward: $75 per 1 lot
This trade was set up after an analysis of the AA chart and recent price action. The reason this spread was chosen over an outright option was because of the lower premium outlay required by the spread. The reward to risk ratio in the spread is also giving a trader great odds on their money. The spread also requires less capital than an outright option. Assuming we had an upside target in AA of just over $28 a play in outright options might setup like the trade below.
The Jan 28 calls are marking at $3.00
Risk: $300 per 1 lot
As we can see above this trade requires a much larger amount of capital and has a much higher breakeven point. The stock needs to move much more for a trader to get any kind of return out of this position when compared to the spread. The main benefit of the outright option trade is the unlimited amount of upside. Below is the chart of AA on January options expiry so we can compare the payoff of the two positions.
On options expiry the stock settled at $35.66 and both positions were in a profit. The spread settled at $1.00 and returned a profit of $0.75. The outright option settled at $7.66 netting a profit of $4.66. While the outright option retuned a larger profi,t the spread had a much larger percentage return. The spread also closed $7.66 higher than it needed to achieve maximum value and full profit.
It’s clear that trading the options spreads was the more efficient way for a trader to deploy capital in a long setup in AA. The main tradeoff is that the profit on options spreads are limited. However as we can see above the stock would have to see a huge upside move before the profit factor of the spread is surpassed by the outright options. For traders who want to play the market but want to save capital this example of a successful trade in AA illustrates why they may want to focus on spread trading.
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