1×2 call spreads are a powerful tool that can be used even by traders who aren’t crazy about options or generally stay away since they view them as very risky. I will go into 2 simple uses that are basically the same play for 2 different purposes. Both of these scenarios are meant for situations where you are already long the underlying stock.
- Stock Repair – this is the nickname sometimes given to buying a 1×2 ratio call spread when you are underwater on a stock. Say you hold a stock that is -10% from your entry for example and you just want out at break even. Even though it may be better to take your loss and move on to the next setup, we’ve all been in the situation where you hope to get out break even though we know that’s just a mental mind trap that hurts more than helps in trading…Bad habit: the desire not to take a loss or having to admit you had a bad trade. Anyway…
Let’s use $GDX for our example. Assume you bought 100 shares of GDX at $28 and it’s now at $25 so you have ~11% loss and you just want out at break even. Today, 2/9, you could buy the March $25 call for $1.24 and sell to open (or short) double the amount of March $26.50 strike calls for 65c (collecting $1.30). So you would be able to put the 1×2 package on for a small credit, 6c credit before commissions in this scenario (a credit is always desired as explained below). Important to note is that the 2nd call you sold is “covered” by the stock you own so it is not a “naked short”. Each call controls 100 shares so if you owned 100 shares of stock the stock repair size would be simply +1 x -2. If you owned 500 shares you would put on +5 x -10.
The reason this is called stock repair is because now you have the opportunity to make 2x the return from $25 to $26.50 ($26.50 = max profit level). So where before you needed a 12% rally to break even, now you only need 6% since you have effectively double the shares from $25 to $26.50 due to the calls. Break-even is now $26.50, not $28.
Important to note the trade-off with this strategy: if the stock goes to $30 you are capped at $26.50 max gain…you won’t lose above that but you also won’t make anything additional either. Timing is also an issue if the move happens too fast as the max profit level gets paid fully only on expiry so it pays to not go too far out with expirations otherwise you may have a situation where you are at max profit price wise but need to wait til expiration for it to fully pay and we know that the stock can obviously fall back below the upper strike again.
Also, the reason it is effectively a free option play…if the stock closes below $25, you lose nothing on the options since you put them on for a credit…both strikes expire worthless…that’s why putting it on for a credit is smart…you paid nothing (or even received $) for the 1×2. You still lose on the stock…but you would have regardless.
Below is a screen grab showing real prices that were used for the examples.
2) Press Your Bet – while the above 1×2 strategy works great for stock repair you can also use it to press your bet for a current position that is not under water or to initiate one that’s turbocharged for the first 6% . It is basically the same play but from a position of strength instead of weakness.
This works especially well when you have a price target say 5-10% higher that you would likely sell your position at. Either buy stock or have an existing stock position that you now pair up with the same 1×2 call spread. Now from $25 to $26.50 you make 6% effectively twice (6% on double the standalone position). Again, if stock is below $25 at 1×2 expiry then you only lose on the stock, not the options. The strategy adds additional gains than the standalone position would have with the stock above $25 at expiry with the Max profit capped at $26.50 and you make nothing more above that. But keep in mind that by not adding the 1×2 option press you would need over a +12% move in the standalone stock before you were better off without the 1×2.
The further out in time you are willing to go the wider the strikes you can use and more potential gain you can play for since the further out of the money strikes can be sold for either more credit or you can use even higher strikes for the same credit as an earlier expiry, lower strike, would get you.