Trading options can be a humbling experience. Traders who are new to options often learn about the leverage provided and start dreaming of making big profits with limited risk. Unfortunately, they tend to lose most or all the premium they pay on their first trade.

It looks so good in theory. You are bullish on a stock, but instead of buying the shares outright, you buy an out-of-the-money call option that will rise in value if the underlying stock does. You pay a relatively small amount – maybe only a dollar or even less – and you have the same upside profit potential of owning 100 shares.

It does work sometimes. If you are lucky enough to have the share price rally right through the strike of your long call and keep going higher, you can end up with profits in the hundreds or even thousands of percent based on your original investment. That’s extremely rare however, and for easily understandable mechanical reasons.

The Skew and the Path

In previous Know Your Options pieces, we’ve discussed the Volatility Skew (also sometimes known as the “smile”) that’s a graphical representation of the implied volatilities of options with the same expiration but different strikes.

While it’s different for every stock and every period in time, in general for options on equities, the skew slopes downward for most of the traded strikes with the bottommost point slightly to the right the current stock price.

When you buy an out-of-the-money call, you’re generally buying a lower implied volatility then the ATM vol. So far so good, right?

Unfortunately, most other sensitivities are working against you now if the stock isn’t rallying fairly hard. Time decay means your long option is worth less as time passes - and that effect increases exponentially as expiration approaches and the value of OTM options goes toward zero.

There is another factor working against the value of that call that’s not as obvious. The skew itself tends to move. You may have noticed that the (CBOE Quick QuoteCBOE - Free Report) Volatility Index (VIX) usually declines when the S&P 500 goes higher and rises when the index falls.

That happens in individual stocks as well. In financial models, this movement is often referred to as the “path.” It’s the path that the ATM point on the curve slides up and down upon as the underlying price changes. Like the skew, the path for each underlying security is different. In general however, when the stock price is falling, ATM implied volatility is rising. When the stock price is rising, ATM vol falls.

That hurts the value of OTM calls on rallies.

What this means for a call buyer is that even if you’re correct about the upward movement of the underlying price, if it happens slowly you’re likely to see the value of your position stagnate or even decline due to time decay and lower implied vols.

So what’s the solution?

When making a directional options trade, it’s a good idea to buy and sell equivalent numbers of contracts. Instead of buying a call, buy a vertical call spread. Though you reduce the (otherwise unlimited) profit potential of simply owning a call, you significantly increase the chances of making some profit and reduce the chances of taking a complete loss.

Subscribers to the Zacks Options Trader service will recognize that Kevin Matras often uses vertical spreads to profit from his directional strategies.

Because you’re also selling an option along with the buy, the spread is less expensive, and you can afford to buy a greater quantity for the same initial investment. Instead of one $5 call, you can buy 5 verticals for $1 - or 10 for $0.50.  

The success of your trade will depend more on your correct prediction about the direction of the underlying and less about moves in implied volatility.

-Dave

David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.