Advanced Micro Devices (AMD) had a great day yesterday. It rallied 2.2% and closed near the high of the day. Today doesn’t look so good. If you put on a bullish option trade yesterday for AMD stock, here’s how you might handle it to cut your loss quicker.
One benefit of vertical spreads is that you are entering into a defined-risk trade. You know the worst-case scenario in advance. Yesterday, a bull call spread on AMD stock looked attractive.
As for price action, AMD stock got support at its 50-day line and recovered back above its 21-day moving average line as well. It looked like it could get back to 115, where it hit resistance at the end of August.
A Bull Call Spread For AMD Stock
Setting up a bull call spread starts with buying a call and then selling another call that is further out-of-the-money.
Selling the further out-of-the-money call reduces the cost of the trade but also limits the upside.
Going out to November expiration, a 110-strike call option on AMD stock traded around 6.00 yesterday. Going further out-of-the-money, the 115 call was around 4.20.
Buying the 110 call and selling the 115 call would create a bull call spread. The trade cost is the difference in the option prices multiplied by 100, or $180. That is also the maximum the trade could lose.
The maximum potential profit on this trade is $320, the difference in strike prices, multiplied by 100 less the premium paid. If AMD stock gets above 115 by the Nov. 19 expiration, that’s a 77% return-on-risk in a less than a couple months.
If you bought 100 shares of AMD stock at yesterday’s closing price, it would cost you over $10,000. While that whole amount is at risk, you wouldn’t let a stock go down to $0, right? But even cutting your loss at 8% would still end up losing $865.
So the bull call spread certainly reduces the risk but it also limits the upside. A close above 115 at expiration nets you the maximum profit of $320 for the bull call spread. But 100 shares of AMD stock would give you nearly $700 profit. You miss out on even more if AMD stock went higher than 115. The bull call spread doesn’t participate at all once you get above the short strike.
You Can Cut Losses On Option Trades Too
You’ll notice in most of these option articles, we talk about managing a trade. For bull call spreads, you could always cut the loss if the spread drops by 50%. That can be an early indicator that the trade is going against you. Rather than take the maximum loss, this bull call spread on AMD stock gets cut if you’re down $90.
Using the stock price as a gauge also makes sense. For AMD stock, a drop below yesterday’s low at 103.44 would be an early indicator that the trade isn’t working out.
That happened about 90 minutes into the trading session today. The 110 call traded around 4.25 (down from 6.00) for a loss of $175 per contract. But the 115 call traded around 2.90 (down from 4.20), which ends up being a gain of $130 since it was a short call position.
So if you used the undercut of AMD stock’s low as your exit on the option trade, you took a loss of just $45 per contract. Sure, there’s still a lot of time left and AMD stock could ultimately hit the 115 level by expiration. But trimming a loss early is also reasonable when a stock doesn’t act as expected.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ.
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