3433-vol. 6 issue 2-3.pmd - iarfc

Volume 6, Issue 2 & 3 109
educating and attracting potential customers and supplying useful information
to their existing customers. There seems to be no lack of information in
this world of technology.
At the same time, a number of books have been written, and a variety
of software programs have been developed. They claim that their main
mission is to help investors better understand options and build more
sensible portfolios using options. Several companies, offering free educational
seminars to potential customers, highlight the profit opportunity, but
without fully explaining the downside risk. They then recommend that the
audience buy their so-called “winning-under-any-market-conditions” software
packages. This is not to suggest that those companies cheat their audiences,
but rather that they disproportionately focus on the opportunity of profits
without revealing the equally important downside potential, leaving the
audience with the impression that options trading is the way to go for
tremendous fortune. Of course, some option trading strategies are not
excessively risky. For example, covered call writing strategies are fairly simple
and can be easily implemented, offering acceptable risk-return tradeoffs. 2
However, many software packages include a number of complex strategies,
such as spreads and butterflies. The sellers of the packages intentionally, or
perhaps unintentionally, foster some misconceptions about these options
trading strategies. Sometimes, the more complicated the strategies are, the
more promising they appear. Therefore, all it seems to take to make money is
to take action (a “just do it” message).
The purpose of this paper is to investigate whether so-called
“simple” options trading strategies really work for non-professional, inexperienced
investors. In other words, the objective is to report what ordinary
investors should expect from using such options trading strategies. One of
the popular strategies, a bull call spread (also called a call bull spread), is the
focus of the investigation. This strategy was chosen because it is simple to
adopt, and can be easily implemented by investors before more complicated
strategies, such as ratio spreads and butterflies, are tried. A bull call spread
typically involves the purchase of a call option at a relatively low strike price
combined with the sale of a call at a relatively high strike price. Most of the
books available from general bookstores include this type of spread (also
called vertical spread) as a sensible trading strategy (see Bittman (2005),
Cohen (2005), Fontanills (2005), McCafferty (2005), Thomsett (2005), Kraus
(2006), etc.). Fontanills (2005) ushers readers into bull call spreads by saying:
“Vertical spreads are basic limited risk strategies, that’s why I tend to introduce
them first. These relatively simple hedging strategies enable traders to
take advantage of the way option premiums change in relation to movement in
the underlying asset.” Kraus (2006) states, “The bull call spread is the most
basic of purchased or debit spreads and is the most commonly used options
spread.” From this, readers may develop the incorrect notions that making
money is only a matter of following the strategy.
Research & Theory