Bullish options strategies for value investors

Bullish options strategies provide value investors a great set of tools to implement a bullish bias in their portfolios with time limits. It is also possible to implement strategies that mimic the level of bullishness you would like to see reflected in the portfolio. Below are the strategies that can be used:

Strongly bullish strategies:

The simplest bullish strategies involve buying calls or selling puts. Long calls or short puts on one of the ETFs covering the major markets (SPY, VTI, QQQ, etc) can be used to build a strong bullish bias that will correlate with the specific market as a whole. However investing in derivatives of the major market indexes has downsides including the fact that it is suitable only when the markets have bottomed out – determining the exact bottom is a gamble best avoided. So, it is best to use a series of non-correlated securities to implement this strategy in your portfolio. The classic dilemma that face value investors using long calls or short puts as a strategy is deciding how much to commit and timing.

Value investors generally have the defining characteristic that they are risk-averse. Basically, they are willing to sacrifice some portfolio performance, if there is a sizable reduction in the associated risk. For this reason, long calls should be preferred over short puts by value investors, as the downside is very high – you can loose a lot more than the premiums received. The only time when it makes sense for value investors to use short puts is as a chance to initiate a long position at a future point at a reduced cost compared to the current market price – the strategy has the downside that assignment is not guaranteed but atleast the premiums will be yours to keep, if that scenario plays out.

Long calls are not a compatible strategy either for risk-averse investors as they represent capital at risk - one of the outcomes of such positions is the loss of all the monies committed to the strategy. So, value investors have to come to terms with this basic fact before committing monies. Given the risk-averse philosophy, it is best to aim to keep no more than a maximum of 2-4% of their total portfolio value invested in long calls.

Deciding on the timing aspect is more art than science. It is however vital as you stand to lose all the capital if what you foresaw plays out a few days/weeks after the expiry date of your position. It is a fool’s game to predict the exact timing of anticipated positive outcomes for a security price. Even when some anticipated event occurs, macro situations can drive the security in the opposite direction temporarily. Even so, chances of success are higher when positioning based on anticipated events/dates: earnings announcement, new product announcements, litigation result, regulatory approval, and favorable macro environment.

Moderately bullish strategies:

The Holy Grail with a long call position is unlimited upside. Long call positions can be altered to a moderately bullish position by using an opposite position that reduces the overall cost. The classic way to do this is using bull call spreads – it allows reducing the cost of a long call option position by using an opposite position that limits the potential upside. Reducing the duration of the contract will also reduce the cost but that is not usually possible - value investors need to incorporate a good margin for error in their estimate of the timing of the bullish scenario playing out.

The bane of short put positions is its large downside risk. The bullish position can be altered to a moderately bullish position by using an opposite position that limits the downside risk. The classic way to do this is using bull put spreads – it allows reducing the downside risk of a short put position by using an opposite position that limits that downside.

1. Bull call spreads: Bull call spreads involve combining a long at-the-money (ATM) call position with a short out-the-money (OTM) call position (higher strike price) on the same security, in the same quantity, and using the same expiration month. You are in effect sacrificing some potential upside of your long call position by collecting some premium upfront from a corresponding short call position that is far enough out of the money so that if you are assigned, you still exit with a very good profit. As an example, say Google (GOOG) is trading at $600 and your research indicates that analysts may be overly pessimistic of the company’s prospects for next quarter. So, you bought a call option on Google (GOOG) shares at a strike price of $600 for $30 (premium of $3000) expiring next month immediately after earnings. The analyst expectations shifted as the earnings date approached and the sentiment change resulted in the stock trading at $640 two weeks from earnings. At this point, you estimate the upside is now somewhat limited to $660 or so. A good way to reduce the cost of your original position at this point is by establishing a new short long position at a strike price of $660 at 20 (premium of $2000). In effect, you have managed to reduce the cost of your original long position from $3000 to $1000 while sacrificing the upside over $660. If the stock trades above $660 at expiry, your gains are limited but still very good: ($660-$600)*100-$1000=$5000. There is not much downside protection other than the fact that you reduced the risk capital from $3000 to $1000. The classic bull call spread strategy involves simultaneously buying ATM calls and selling OTM calls on the same security and expiration month, rather than waiting for a period of time to establish the latter position. The cost reduction will be lower when using that strategy as far-out-the-money calls will have very limited premiums associated with them.
2. Bull put spreads: Bull put spreads involve combining a long at-the-money (ATM) put position with a short in-the-money (ITM) put position (higher strike price) on the same security, in the same quantity, and using the same expiration month. You are in effect reducing the downside risk by sacrificing some premium to purchase a protective put.  As an example, say Google (GOOG) is trading at $600 and your research indicates that analysts may be overly pessimistic of the company’s prospects for next quarter. So, you sold an ITM put position at $630 for $35 ($3500 premium) expiring next month, immediately after earnings –the idea is to keep the premium, when your bullish prediction plays out. The position has no downside protection. For example, if the stock dropped to $500 at expiry, you stand to loose a whopping $9500 (630-500-35), almost three times the premium received. To avoid this situation, you buy an at-the-money (ATM) put position simultaneously at $600 for $10 ($1000 premium). In this scenario, if the stock dropped to $500 at expiry, you loose only $500 ($9500 – $9000). The cost of reducing this downside risk was the put premium of $1000 you paid for the long ATM put position.

The bull spreads above are called vertical spreads as the strike price is used to implement the spread. A variation that uses the expiry to implement the spread is called calendar spreads. Longer term long calls are offset by short-term short calls.

Mildly bullish strategies:

Long positions represent a strong bullish stance on the company concerned. The strong bullish stance of a long position can be reduced to a mild bullish stance by selling covered calls. Out-of-the-money covered calls are preferred unless you think the stock price is already over-extended. The covered call premium provides a small amount of downside protection. Also, out-of-the-money covered calls provide a way to exit the stock at a nice profit, if the stock goes up. There is no downside protection beyond the call premium realized upfront. Premiums go up as the time to expiration increase but chances of getting assigned also increase. Also, a series of shorter term option positions realize more premium income compared to a leap position of same duration and so in most situations going with shorter-term duration (three months or less) is the most beneficial when implementing this strategy.