The S&P 500 is up an astounding 18% year to date. That puts its Jan. 4, 2022, all-time high above 4800 within reach. Nevertheless, if the massive run this year loses steam and resistance is seen at this level, one useful options tool to use is a call ratio spread. The SPDR S&P 500 ETF can be the vehicle to use for the trade.
Setting Up A Call-Ratio Spread On S&P 500
A call-ratio spread consists of buying one lower strike call and then selling two higher strike calls. SPY stock can be our S&P 500 proxy and is currently trading at 453. The trade is buying one Dec. 15 call at a 460 strike while selling two Dec. 15 calls with a 470 strike. This trade can currently be placed for a credit of $4.75 a share. This equates to a gain of $475 per spread if SPY stock falls or remains flat below 460 on expiry.
If the S&P 500 goes up mildly by the expiration date, you could see that profit increase. If SPY stock finishes above 460 the profit will increase, up to the maximum profit if SPY stock hits exactly 470 on expiry. The short calls expire worthless in that case and you keep the full premium from them. You also have a $1,000 value for the long call for a total profit of $1,475.
Further increases in the S&P 500 above 470 at expiration can still be profitable up to the break-even point of 484.75 on SPY stock. Beyond this level, the trade will start to lose money. One short call will be offset by gains in the long call. But since there are two short calls, the losses on one of the short calls will continue to mount as the S&P 500 makes further gains.
Outlooks And Alternatives For SPY Stock Option Trade
It is important to note that despite the maximum profit occurring just below all-time highs, this trade is bearish on inception. While the trade will make money in most situations, investors will lose a significant amount if SPY stock moves explosively higher. As the risk on this trade is undefined because of the uncovered short call, investors need to be very aware of risk management before entering this trade.
If the undefined risk is beyond your comfort zone, a more conservative choice for investors is buying an additional out-of-the-money call option. In this trade, investors could buy a 490 call with the same Dec. 15 expiration for around $350. This eats into the profit potential but still allows the trade to experience a profit in most scenarios for the S&P 500. More importantly it also limits the maximum loss to under $1,000.
Another choice is to set a mental stop-loss level for the original trade. For example, a trader could say that if at any point the trade hits a loss of $1,000 on the SPY stock option trade, they would close out the position. This would be especially helpful in a sudden upside move in the S&P 500.
It is also helpful to consider an investor's overall positioning in a portfolio. If an investor has a long-only portfolio of diversified stocks, they may be happy taking a loss on this spread so long as their other positions are performing well.
