My Alternative Strategy in a Volatile Market

Dear Reader,

I like the rewards of trading long calls, but with the extreme volatility in our markets, there is a way for you to reduce risk in this choppy market.

You may have mixed feelings and a bit of anxiety about taking on long calls in this market, but there’s a simple solution for you to reduce the risk of market chop.

I’m talking about selling a call alongside the one you buy, which creates a vertical call spread.

It’s a simple alteration to your call trade, and by doing it you can still make money on your bullish trade even if the market is choppy.

And, in today’s volatile market, it can mean the difference between winning and losing.

Let me explain to you how it’s done – it’s easier than you might think.

Market Volatility Remains High with Plenty of Uncertainty

I can see two big struggles traders have had to cope with this year – irrational, flash market extremes and persistent levels of high implied volatility.

You can almost point to any timeframe this year and see the rapid-fire market moves. In the latter part of May, the S&P rose confidently over several days only to lose half of the gains in a single trading day.

Then over the week of September 6-12, the market grew steadily by five percent, only to lose 90% of the growth on September 13th.

That’s the kind of turbulence we’ve been dealing with regularly this year, and it you’ve likely felt it!

A great tool you can use to gauge whether implied volatility is above or below average is the volatility index, VIX.

As I look back over this year, the better parts of January through March, April to July and even August to the present, the VIX has been in the upper half of its annual range – between 25 to 34.

This simply illustrates that option premiums have been inflated for a good part of this year – and this translates into paying too much for options.

The axiom, “buy low, sell high,” can mean the difference between success or failure in option trading, and with implied volatility at extreme levels, it can be more difficult to find successful option trades.

There’s a way to exploit the high IV problem facing option traders today, however – the vertical call spread.

Don’t get me wrong, I’m happy to trade call options anytime the situation warrants it, but I’ll also take on a vertical call spread which can harvest its profits as IV is falling.

There are subtle differences between most option strategies, but one distinguishable difference between a long call option and a vertical call spread is the impact of implied volatility.

Falling Implied Volatility Hurts Long Calls

You probably know by now, but time is always against option buyers, and as you can see from the illustration below, falling implied volatility can take its toll on the trade as well.

When implied volatility is on the rise, it inflates option premiums, which is a great way to enhance your long call trades when it occurs.

But, when you’ve purchased a long call and IV falls, it feels a little like dropping a Benjamin Franklin after an ATM cash withdrawal and not realizing it until you get home.

(Falling IV Comparison: Long Call vs Vertical Call Spread)

In the comparison graph above, you can see that a long call trade can lose significantly more of its value when IV is declining than a vertical call spread trade might – and it is very possible for implied volatility to decline when stock prices move horizontally over time.

Trading long call options is certainly a rewarding strategy under the right circumstances, but there are benefits to trading vertical call spreads when IV in the broader market is at extreme levels.

Consider the Differences Between a Long Call and Vertical Call Spread

The greatest benefit to a long call trade is the unlimited profitability potential. As long as the stock’s price keeps rising, we can continue to make higher returns.

There is a caveat to this – we don’t expect a stock’s price will ever just keep running infinitely. When buying call options, we expect price to move favorably for some time, and then flatten or even fall back down, so we never expect unlimited returns.

The vertical call spread on the other hand has a fixed profit amount.

Another huge difference between the long call and the vertical call spread is the impact of implied volatility.

I buy long calls when I expect IV to rise. Otherwise, falling implied volatility hurts the long call because it erodes the option’s extrinsic value quicker. On the other hand, the vertical call spread can benefit from the decline in IV.

Although the rate of return is fixed on a vertical spread, there are several benefits to trading them as I’ll point out below.

The Benefits of Call Vertical Spread Trading

  • Verticals can bring affordability to high-priced options.
  • Verticals can benefit from falling volatility.
  • Profits and losses are capped on the vertical call spread – you know exactly what the best- and worst-case scenarios will be.
  • Trading the vertical is a way to subsidize the cost of an individual long call.
  • Vertical call spreads can profit whether the security rises or even stays flat in some cases.

With the benefits outlined above, let me tell you how easy it is to construct a vertical call spread.

How To Create a Vertical Call Spread

In the image below, I’ve highlighted the $369 call, the stock’s price and the $373 call option as well.

In this example we might purchase the $369 call by itself, and then expect the security to rise high enough to take a profit, but to avoid some of the issues associated with long call buying as I described earlier, we’ll turn it into a vertical call spread instead.

So, to create a bullish trade in the form of a vertical, we simply need to SELL another call with a HIGHER strike price.

In this case, if the $369 call were to be bought, we could simultaneously SELL the $373 call – thus creating a vertical call spread.

Here are some tips to help you put together a vertical call spread:

  • Simultaneously, BUY a call to open, and SELL to open a HIGHER strike price.
    • Buy the $369 strike price
    • Sell the $373 strike price
  • The cost of the vertical call spread is your maximum loss amount.
    • ($14.78 – $12.51) = $2.27 debit, which is the maximum loss amount.
  • Now, take the difference between your strike prices and subtract the net debit to determine the maximum gain amount.
    • ($373 – $369 = $4), minus the $2.27 debit equals your $1.73 maximum gain.

When we construct the vertical as described above, we’ll have successfully created a bullish vertical call spread.

Now it’s time to make some money with them!

How Call Verticals Make Their Money

Each call spread will have a breakeven point somewhere between the two strike prices. However, to achieve the maximum gain, the security must trade ABOVE the higher strike price by expiration.

Just like any other successful option trade, the vertical call spread can be closed out any time before it expires.

To calculate the return on investment for the vertical call spread, simply divide your gain on the trade by your net debit.

The great thing about vertical call spreads is that it doesn’t matter when the stock’s price moves higher.

If the stock’s price moves sharply higher shortly after taking on the trade, the gains can be locked in right away, but…

If the stock’s price flounders around and doesn’t rise above the higher strike price until its final trading days before it expires, we can still make the maximum gain on the trade.

This is why I wanted to introduce you to the vertical call spread. In today’s choppy market, the vertical call spread trade benefits from the rising security (whether it happens sooner or later) and falling implied volatility – making it possible to capture 100% of your profits in the end.

Until next time,

Tom Gentile
America’s #1 Pattern Trader

Join Tom each Monday through Wednesday at 12:00 p.m. ET as he discusses a range of strategies to make money in a strained market environment.

Did you miss the Live session? Watch Tom’s replays!

Leave a Comment

View this page online: