When stock prices keep going up, at some point they tend to fall. But you don’t know when. If you’re trading stocks that have gone up in price, you might want to consider options strategies such as time strangles, back/ratio spreads, and rolling collars as a potential protective measure.
Vertigo (n.): A feeling of dizziness associated with extreme heights.
Physical heights aren’t the only thing that causes vertigo. Traders get vertigo when they worry that a bull market has gone parabolic or is long in the tooth. They don’t want to be left behind as a rally rages on, but the fear of missing out can mess with your head. Luckily, there are options strategies that can help you remain long and strong with defined risk built in if things don’t hold up.
A seasoned option trader can look at existing market conditions, mash familiar strategies together, or use old strategies in a fresh way to take advantage of what the market is offering. Consider three approaches to get you started.
Backdrop. You expect an imminent move higher in a stock but feel a strong pullback or correction might be around the corner. You want the immediate unlimited upside potential of a call but with defined risk or potential profit from a downside move if the market suddenly reverses.
Setup. A traditional long strangle has an equal number of long calls and puts (typically both out of the money, or OTM) on a stock with the same expiration. For example, with a big stock trading at approximately $500, a traditional strangle might look like:
Buy one 90-day 510 call for $27Buy one 90-day 490 put for $27Cost = $5,400 per strangle (also your maximum risk)
With a time strangle, you’re also buying an equal number of short-term puts and calls, but they expire on different days. Maybe you buy longer-term calls that have 90 days to expire and buy puts that expire in one week to 30 days. Here’s what it might look like:
Buy one 90-day 510 call for $27Buy one 30-day 490 put for $9Cost = $3,600 per strangle (also your maximum risk)
What happens next? Looking at figure 1, with a stock trading just under $500, notice that if the stock moves higher right away (pink line), theoretically the trade makes a profit when it crosses above $503. However, if the stock collapses, a plunge of about 4% below $478 theoretically produces a profit as well, while the loss in between is nominal.
The intention is to stay in this trade for as little time as possible. The blue line in figure 1 represents the profit curve of the shorter-term put (30 days) as shown on the thinkorswim® platform. Should the breakout (or breakdown) not happen within three to five trading days, time decay (theta) sets in.
FIGURE 1: TIME STRANGLE. Enter your trade on the Analyze tab and view the Risk Profile to see the theoretical profit and loss of the strategy. Chart source: The thinkorswim platform. For illustrative purposes only.
Backdrop. The shakiness of a bull market gives you pause. You’re looking to maximize your returns with unlimited upside potential, but in a way that if the market reverses, you see only a small loss or even a small profit.
Setup. A call back/ratio spread combines a long call with a short call vertical spread. Simpler still, you can buy two OTM calls and sell one near- or at-the-money call with the same expiration. The goal is to set up the trade so the short call pays for both long calls and possibly nets a credit.
See figure 2 for an example. With the stock trading at nearly $500, a call back/ratio spread might look like this:
Buy two 90-day 550 calls for $13.05 eachSell one 90-day 505 call for $34.65Credit = $855 per spread (max risk is $3,645)
This position is opened with a credit, meaning the options you sell generate more cash than the cost of the long options. This eliminates downside risk as long as the stock price stays below the short strike through expiration—which some traders might consider attractive when markets feel toppy. If the stock moves lower, and if both options expire worthless, the credit becomes the profit.
It’s crucial to recognize that back/ratio spreads come with significant theta (time decay) risk, because the options rapidly lose value as each day passes.
What happens next? In figure 2, the stock is trading at $497. If the stock moves higher right away (pink line), all else being equal, the trade theoretically makes a profit. If the stock collapses, the loss is relatively nominal. But what if you decide to hold on to the trade through expiration? If you took in a net credit at the onset of the trade and the stock finishes below the short strike, you could keep the entire credit, minus fees. Keep in mind, there’s the risk of early assignment on the short option. Also it may be a good idea to be aware of ex-dividend dates and manage your trade when the stock price is between $505 and $550, especially if the expiration date is approaching.
The blue line in figure 2 represents the profit curve of the strategy. The intention is to stay in this trade for as little time as possible. The Achilles’ heel for this strategy? If the stock doesn’t move at all. Beyond a couple of weeks, if the stock sits still or rises slightly, time decay (theta) will start to produce greater losses. So, it’s a good idea to take price and time into account for your exit strategy.
Backdrop. The collar is a conservative, slightly bullish options strategy that allows some limited upside potential while providing some protection against losses below a specific price of your choosing. Most often, the options “collar” can be placed around your stock without any further investment, excluding fees.
Consider two primary reasons you might want to place a collar trade:
Setup. To create a collar, for every 100 shares of stock you own, you’d buy one protective OTM put and sell one OTM call (of the same expiration), approximately equal distances from the current stock price.
For example, placing this collar involves the following:
You own 100 shares of XYZ @ $500Sell one 550 call for $13Buy one 450 put for $13Cost = $0 (plus transaction fees)
In this example, the $13 put is paid for by the $13 credit received from the sale of the call, netting you a zero-cost hedge (except for fees). In exchange for this, you’ve capped your upside to 10% from here.
What happens next? From the profit curve of the collar in figure 3, notice that as the stock moves higher, you won’t make the same dollar-for-dollar profit as the stock anymore (see pink line). That ship sailed when you locked in a max loss of 10% with your collar hedge. Instead, your profit-and-loss curve basically resembles a long call vertical spread. If the stock suddenly jumps to $550, time decay works in your favor and you get, in theory, closer to $5,000 of unrealized profit with each passing day.
To “roll” a collar, if the stock moves higher toward the short call strike or soon after, you could consider taking off the put/call combo and placing a new one around the higher stock price. You’d repeat this until either the stock collapses or you’ve achieved your profit target.
You want to reset the collar as the stock moves higher to avoid assignment of the short call prior to expiration, in which case you’d be forced to sell your shares. With a lot of time left in the call, assignment isn’t likely; however, short options can be assigned at any time up until expiration regardless of the in-the-money (ITM) amount. It would cost more for the owner of the option to exercise than to simply sell, because by exercising, the owner would lose any time value in the option. (However, the owner may have other reasons for exercising the option, like an upcoming dividend or to cover another position.)
But this doesn’t mean assignment can’t happen to you. As the stock rises such that the call is further ITM, the time value of the call decreases further, posing a greater risk of assignment. Once the stock goes ITM on the short call, at some point you’d simply roll the collar by purchasing the short call back, selling the put, and resetting the collar around the new higher price of the stock. Keep in mind that rolling strategies can entail additional transaction costs, including multiple contract fees, which may impact any potential return.
Big stocks can get bigger. But when they do, they have further to fall. When you understand the language of options, you can start to stitch together multiple strategies and concepts using different types, expirations, and strikes, depending on market conditions. So when everything seems to be going up, you can consider engaging various strategies to potentially create defined risk profiles when things change without compromising too much upside when they don’t.
Itching to try out these strategies?
Entering spread orders on the thinkorswim platform is pretty straightforward. It may be a good idea to try them out in your paperMoney® account before placing the trades in your real money account.
From the Trade tab, enter the symbol of the underlying, expand the Option Chain, and select the Spread menu that’s along the top.
To place time strangles:
To place back/ratios and collars:
While options trading involves unique risks and is definitely not suitable for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the potential benefits and risks of trading options.
Spreads, straddles, and other multiple-leg options strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
Kevin Lund is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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