When Can Traders Expect Profits?
Recently, a subscriber asked about the possible profitability of a specific trade. They wanted to know how much the stock price would need to increase for them to consider their trade successful, especially since it was sitting at $201.33.
The trade in question was a call spread on Powell Industries, Inc. (NASDAQ: POWL), a smaller industrial company that's focused on meeting the rising demand for energy resources.
Last month, the trade consisted of a vertical spread that’s set to expire soon. It involved purchasing $185 strike calls and selling $190 strike calls, all for a total net cost of $1.60. If the stock ends up closing above $190 at expiration, the spread can reach its maximum value of $5. This would represent a remarkable 213% return on the original investment of $1.60.
In my response to the subscriber, I indicated that a profit on the POWL trade could be secured right now, but it would likely be around a 100% gain. This expectation comes from the time left until expiration, highlighting a notable drawback of trading call spreads.
The Limitations of Call Spreads
One major limitation is that the short call leg can restrict profits if you decide to exit the trade before it reaches expiration. For instance, while POWL recently closed at $206.34—well above the maximum profit point of $190—it’s unlikely that you could sell this call spread for a net credit of $5 at this moment. Instead, you might be looking at a return of around $3.20. That’s still a solid 100% gain on your original investment, but it falls short of the maximum potential profit. To aim for a higher profit, keeping the stock price above $190 as expiration nears is the best strategy.
The Advantages of Call Spreads
On the flip side, call spreads come with several benefits. One key advantage is that they allow traders to enhance potential profits compared to simply holding shares of the stock for similar price movements. When we entered the call spread for Powell Industries, the stock was priced at $162. This means by December 20th, we only need a modest increase of 17% to achieve returns exceeding 200% on this trade.
Another plus of using call spreads is their cost-effectiveness. When dealing with high-priced stocks, buying a call option can be prohibitively expensive. For example, purchasing the $190 strike calls alone might have cost upwards of $20 each, yet through a call spread, the total cost came down to just $1.60.
Moreover, having a short leg in a call spread acts as a buffer against drops in implied volatility (IV), particularly during earnings announcements. Typically, IV decreases following earnings releases, which can negatively affect the value of options that are about to expire. However, in a call spread, the decline in IV affecting the short call can help reduce the adverse impact on the long call's value.
Grasping Call Spreads for Smarter Trading
Call spreads can be a valuable tool for any trader who understands their benefits and limitations. In our case with Powell Industries, we chose a December 20th expiration because of the company’s next earnings release scheduled for early December, making it the earliest expiration option thereafter. With favorable valuations and positive macroeconomic factors influencing energy demand, there’s a good chance we could reach near-maximum profits from this trade.
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Frequently Asked Questions
What is a call spread?
A call spread is an options trading strategy that involves buying one call option while selling another with the same expiration date but a different strike price.
What are the advantages of using call spreads?
Call spreads can enhance potential returns compared to owning the stock directly, while also keeping the initial costs manageable.
What are the disadvantages of call spreads?
The primary drawback is that the short call leg can cap profits, especially if you exit the trade early.
How do call spreads protect against volatility?
The presence of a short call leg can help cushion the negative effects of falling implied volatility, especially around major events like earnings reports.
What should I consider when using call spreads?
Be mindful of the stock's performance, the timing of earnings announcements, and your risk tolerance before engaging in call spreads.
