One of the challenges facing stock buyers is that even if the best performer in an industry is chosen, a trader will still struggle to make money if the industry falls out of favor. This problem becomes magnified when moving from buying stocks to buying calls, since options may expire before sentiment toward the group changes.
But there is a solution. Just as some traders like to isolate the quality of their favorite stocks by shorting industry exchange-traded funds (ETF) against them, a trader can manage both sector and premium risk by offsetting purchased calls with short ETF calls or call spreads.
Example:
David believes ABC Oil Corp. (ABC), currently at 57, will significantly outperform its peer group during the next several months. He purchases 6-month 62.50-strike calls at $2.50. At the same time, with an energy ETF such as the Select Sector SPDR Energy Fund (XLE), trading at 51.50, he sold a 6-month XLE 57-strike call for $2.35, paying for virtually the entire cost of the ABC call. (Note that one benefit of this strategy is that ETFs often have options with one-point strikes, making it easier to find a call to sell with the time and pricing characteristics needed.)
ABC rises nearly 20% to 69 by expiration, while XLE has moved up a little less than 15% to 59. The long call position is worth $6.50 (69-62.50), while the short is only worth $2 (59-57). So, for a tiny net investment of 0.15 before commissions, the net profit is $4.50. Meanwhile, the nature of the position has largely eliminated exposure to both time decay and industry risk.
Of course, if David’s premise was incorrect, he would lose money. One nice thing about this strategy, though, is that the short is on an index, so he don't have the same degree of risk on a short position (via a takeover, for instance) that could be found on an individual name. Still, it's important to keep in mind that if the ETF goes above the strike price of the sold call. The position will need to be closely monitored in the event that it could be exercised.
In the second scenario, ABC underperforms XLE, with both rising to 60 (recall that ABC started from a much higher point). The sold call is now 3 points in the money and is trading at $3.50. Meanwhile, the purchased call is 2.5 points out of the money and is trading at $1.00. The problem here is that the short call is going to be much more sensitive to general industry sentiment than the long call.
The position is best handled by unwinding the position and taking the additional 2.5-point loss. While this is disappointing, keep in mind that the original thesis turned out wrong and that the loss is still not severe.
One issue to be aware of whenever a trader sells (or "writes") naked call options is that the broker will require the trader to post a certain amount of capital, known as margin, to protect them if the position goes against the trader. After all, the losses on the trade are theoretically unlimited, although prudent risk management will keep them from going beyond a trader’s comfort level. A broker might require an option trader to keep an amount in cash equal to approximately 25% of the value of the underlying security. So to write an unhedged call on a stock at 60 would require a trader to set aside $1,500 for each short contract on this stock.
Note that this strategy will have multiple break-even points. If ABC closes below the 62.50 strike price of the purchased call, the best outcome will be a loss of the initial net premium. Any value the short call ends up with will increase the loss. On the other hand, if XLE closes below the 57-strike call, ABC will need to be 0.15 in the money, or at $62.65, to break even (before commissions, of course).
If ABC closes at 68, the purchased call will be worth 5.50 (68-62.50) or net $5.35 given the $0.15 net premium paid to open the trade. So, if the XLE call is worth less than 5.35, the trade will be profitable. That means that XLE must stay below 62.35 for the trade to be profitable before commissions. These numbers include neither commissions nor any slippage on the unwound trades, in which the trader sells the ABC call and simultaneously covers the short XLE call.
Notice in this example that a trader can break even with ABC slightly underperforming XLE. The break-even gains with ABC at 68 are 19% on ABC and 21% on XLE. That is because the implied volatility of the purchased ABC option was slightly lower than that of the sold ETF option. This will be the case at times, but in general the reverse will be true because individual stocks tend to be more volatile than composites. Indeed, the possibility of a larger move from a single stock than from an index is largely the idea behind this trade. But a trader needs to be careful that the purchased option is not so expensive that it significantly reduces the profit potential even if his expectations prove to be correct.
Strategy Pros and Cons:
Pros:
Minimizes exposure to broad market conditions
Minimizes exposure to industry-specific conditions
Focuses trade on outperformance by the selected stock
Minimizes net cash outlay
Nearly eliminates exposure to time decay
Cons:
Open-ended upside risk on short call
Significant capital required for short call position
Trade requires regular monitoring to ensure desired risk profile maintained
Potential slippage on position unwinding (selling the purchased option and buying back the sold option)
