By Dmitry Pargamanik
What is attractive about this EEM call spread?
If you are bullish on EEM, then you will want to find a strategy that benefits if the stock goes higher. Using EEM options you can try to find a bullish opportunity that has a statistical edge and, theoretically, a good deal (i.e. offered at a discount). For simplicity, think of the edge as getting a little extra cushion for taking a risk. The above call spread was programmatically scanned as a bullish trade opportunity because it is trading at a $0.18 discount to its estimated value.
The following infograph for EEM displays how the the theoretical value was determined.
NOTE: The probabilites were caculated using actual historical data.
Let's walk through this trade idea
We want to determine if this trade opportunity is a good deal and why.
The first thing we want to do is list out all the information that is important to evaluate the trade. We will split the information into knowns and unknowns.
What we know
Strategy: EEM Debit Call Spread
| Buy: | 28-Oct-22 34 CALL |
| Sell: | 28-Oct-22 35.5 CALL |
| Market Price [Debit]: | $0.99 |
|---|---|
| Trading Days Left to Expiration: | 20 |
| Stock Price: | $35.01 |
Potential Value
Now let's figure out the potential value of this spread at the end of 20 trading days (when these option contracts expire). The value will depend on the stock price on Oct 28, 2022 (i.e. on the expiration date, 20 trading days as of the time of this writing).
| Scenario | 1 | 2 | 3 |
|---|---|---|---|
| Stock Price: |
Below $34 [Drops more than -2.9%] |
Between $34 and $35.5 [Stays Between -2.9% and +1.4%] |
Above $35.5 [Goes up more than +1.4%] |
| Value of Spread: | $0.00 | $0.00 to $1.50 | $1.50 |
What are the outcomes for this EEM bull call spread?
Scenario 1: If the stock falls below $34.00 (i.e. drops more than -2.9% from the current price of $35.01), then both calls will expire worthless and this spread will be worth $0 at expiration.
Scenario 2: If the stock is anywhere between $34 and $35.5 (i.e. stays between -2.9% and +1.4%) at expiration, then the spread will be worth $0.00 to $1.50 (depending on the price of the stock at expiration). Note: By clicking the Report tab on a live trade card, you can see the various outcomes for the spread value within the Payout Diagram section.
Scenario 2: If the stock is above $35.5 (i.e. increases by more than +1.4%), then the spread will be worth $1.50.
What we don't know
The problem is that we don't know where EEM stock price will be at expiration (uncertainty). If we did know, then the value of this spread would be easy to calculate.
Therefore, the next best thing we can do is use historical data to estimate the probabilities of the 3 scenarios above (similar to how an insurance company calculates the probability of accident claims).
How to estimate the call spread value
Using historical data, let's find out the following to see how the stock tended to perform over a 20 day trading period.
How frequently did EEM
- Drop by more than -2.9% (Scenario 1)
- Stay between -2.9% and +1.4% (Scenario 2)
- Go above +1.4% (Scenario 3)
Fortunately, we have the benefit of computers to do the tedious work for us. We will use 4 years of data and adjust for earnings dates and implied volatility events.
Here are the results:
|
Study: Theoretical Value of Spread Using Historical Stock Return Distributions 4 Years of Data, 20 Day Hold Intervals Exclude Earnings Periods, 28 Total Observations |
|||
|---|---|---|---|
| Summary Results | |||
| Stock Returns | At or Below -2.9% | Between -2.9% and +1.4% |
Above +1.4% |
| # Occurrences [%] | 4 [14%] | 7 [25%] | 17 [61%] |
| Avg. Theo Spread Value for Stock Return |
0.00 | 1.06 | 1.50 |
| Theoretical Value | 1.17 | ||
(Click on the Report tab on the top right of a live trade card to see this data in the Theoretical Value Analysis section.)
The historical data shows that, over a 20 day period, EEM dropped more than -2.9% (Scenario 1) in 14% of the observations. Also, 25% of the time, EEM price closed between -2.9% and +1.4% for an average value of $1.06. And finally, EEM increased by +1.4% (or more), 61% of the time. Therefore, to calculate an estimated value we perform the following: (14% X $0.00) + (25% X $1.06) + (61% X $1.50). Which comes out to $1.17.
In other words, if we applied the spread characteristics (same number of days to expiration, strikes with the same distance from stock price) historically, the average end value for this bull call spread at expiration would be $1.17.
Key Takeaway
The EEM bull call spread is a great way to play a bullish outlook on the underlying stock, with limited risk. Based on EEM historical stock behavior, the strategy has a 18.7% theoretical edge.
How to Find More EEM Bull Call Spread Strategies
How you can find bull call spread trade ideas for other stocks
See more trade ideas for EEM
And if you want to find more bull call spreads for other stocks, go to the bull call spread screener
NOTE: Stock and option trading involves risk that may not be suitable for all investors. Examples contained within this report are simulated and may have limitations. Average returns and occurrences are calculated from snapshots of market mid-point prices and were not actually executed, so they do not reflect actual trades, fees, or execution costs. This report is for informational purposes only, and is not intended to be a recommendation to buy or sell any security. Neither Market Chameleon nor any other party makes warranties regarding results from its usage. Past performance does not guarantee future results. Please consult a financial advisor before executing any trades. You can read more about option risks and characteristics at theocc.com.
The information is provided for informational purposes only and should not be construed as investment advice. All stock price information is provided and transmitted as received from independent third-party data sources. The Information should only be used as a starting point for doing additional independent research in order to allow you to form your own opinion regarding investments and trading strategies. The Company does not guarantee the accuracy, completeness or timeliness of the Information.
