We have maintained in this column that setting up futures position is best for breakout trades. Does this mean that options are never optimal for such trades? This week, we discuss when you could consider initiating long option positions to take advantage of likely price breakouts.
Runaway prices
You cannot capture a one-to-one movement in the underlying with long options position. This is because time value, a component of the option price, declines with passage of time. That is the reason why futures is preferable to options when you are confident of a likely price breakout. That said, you could consider setting up long options position in two instances.
The first instance is when you believe that the underlying is likely to face a stiff overhead resistance after traveling moderate distance from the breakout price. It is easier to setup a bull call spread in such cases. You could go long on an immediate out-of-the-money (OTM) call and short a strike above the resistance level. If you are an experienced trader, of course, you could go long on futures and short a higher strike OTM call.
The objective of attaching a short call to a long futures or a long call position is to capture gains from time decay. Note that setting up a bull call spread as opposed to a long futures-short call strategy requires you to be more agile in managing the position. This is because of two reasons. One, if the underlying moves up quickly, the long immediate OTM call will become ITM. This will cause liquidity in the strike to decline, as option trades typically prefer immediate OTM and two strikes above. You must, hence, sell the long call to capture gains. And two, the longer you hold the spread position, the greater the net loss from time value. This means setting up a bull call spread for breakouts will be optimal only if the underlying breaks out soon after you initiate the position.
The second instance when you could setup a bull call spread is to do with the lower capital outlay compared to futures position — when a significant proportion of your trading capital is locked up in multiple positions and you still want to setup a position to take advantage of a likely price breakout. An options position may be meaningful, given that a spread trade requires lower capital than long futures position.
Optional reading
Sometimes, an underlying could gap up immediately on breakout. If so, it is highly likely that you would close your position the same day you initiated the trade. In such cases, options will generate similar gains as futures, as time decay or theta will be negligible. Note that the argument about using options for price breakouts also works for price breakdowns. In such cases, you will setup a bear put spread — go long on an immediate OTM put and short a strike immediately below the underlying’s support level.
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