Matching Your View to Market Conditions

There are several ways you can express a bullish view on the direction of the ASX. While most option investors are familiar with basic call and put options, there are combinations that you can put together that can help you generate a cost-effective structure that allow you to take advantage of the current market environment.

The ASX has recently broken out above trend line resistance and poised to move higher. To take advantage of a rise in the major average you could purchase a call option, that expires at a date in the future. Recall, a call option is the right but not the obligation to purchase a stock or index at a specific price on or before a certain date. There are several inputs that make up the value of a call, and one of the most important is implied volatility.

Implied Volatility

Implied volatility is the markets estimate of how much a security will rise or fall over the next 12-months. Since the value of an option is based on the probability that a stock will be “in the money” by the expiration date, determining how far the market might rise or fall is an important element of determining the value of an option. When implied volatility is elevated, call options can be expensive.

One way to reduce the cost of a call option if implied volatility is rich, is to enter into a vertical call spread. This type of option structure requires that you purchase a call, and simultaneously sell a further out of the money call, which will help you reduce your premium outlay. For example, if you think the ASX will rise, but don’t want to just purchase a 6,000-call option, you could simultaneously sell at 6,500 call and create a call spread. Since you are buying and selling options, your premium will be reduced by the premium you receive from the ASX 6,500-call option. While your premium outlay is reduced, your maximum gain is also reduced to 500, which is the difference between the 2-strike prices (6,500 – 6,000).

Another structure you could enter is a covered call. Here you could purchase the ASX, and sell an out of the money call. For example, if you bought the index and sold an ASX 6,000 call, the premium you receive from selling the call, would protect you if the ASX moved lower. The downside is that if the price of the ASX moved above the 6,000 level, your shares would be called away.

While options provide excellent tools to generate revenue, there are many structures you can create that will allow you to take advantage of different market conditions. You need to combine your view of a security with the premium values of options to generate the most cost effective option structure.