Trade The Journey

Trade The Journey

Trade Review: Caterpillar (CAT) Bull Call Spread

Trade Review

Trading is difficult even when you’re in a profitable position because there’s always a concern that you may mismanage the position. Letting your profits run and cutting your losses short sounds good, great even when you’re reading about it. However, having the ability to put this old trader’s maxim to use is harder than it sounds.

Caterpillar (CAT) went into the green almost immediately and while it wasn’t near my profit target, I felt good about its chances of reaching my profit target. I had several trades to select from and I felt a Bull Call spread might work best with CAT.

Spreading is used for many reasons, some use to it hedge, some use it to decrease the risk of an outright position and others use spreading to take advantage of an edge. In the past, I would buy calls or puts outright and I’d say that most of the time I ended with a loss, sometimes a huge loss. I didn’t have a position open on the other side of the call or put to limit my losses when the position didn’t work in my favor.

Most professional traders use spreads for this very reason. Since the market involves uncertainty why not hedge your risks?

All the trades that I selected were bull call spreads because I felt the market had a good chance of rising during the week. There were several economic reports scheduled to be released during the week that had the potential to move the markets in either direction. None being more important than the Consumer Price Inflation Report and to a lesser extent the Producer Price Inflation Report. The retail sales report and the University of Michigan Consumers Sentiment report were also being released.

Earnings were also scheduled to begin at the end of the week with Banks taking center stage. Although I prefer to trade when the week is light in terms of reports, these data reports and earnings releases were bound to add some volatility or price movement. Volatility usually rises when the market falls and vice versa when the market rises. This is not a hard rule.

Going into the trade the VIX was in a sideways trend and most of the indices had turned upward after reaching a low in February. Most of the indices have recovered.

Trade:

Caterpillar (CAT)

I entered this trade by buying the at-the-money option and selling a somewhat out-of-the-money option. The ADX showed that the trend was weakening on the downside. The ADX, which is the red line, is based on the strength of the trend, not the direction. For direction, we can look at the Directional Movement Index. Below is the calculation for the Directional Movement Index from Investopedia.

Although the math can be a little daunting, this indicator can provide signals of when to take the long or the short trade. It also acts as an indicator of momentum. In this trade, the -DI is far above the +DI but is trending sideways after making a new high. The +DI is in a solid uptrend so I figured there might be a change in the price trend. The RSI is near 50 and faced some resistance around that level. The RSI is also a momentum indicator measuring the average gains to the average losses. 

While the daily chart which is long term tells one story, the short-term 15-minute chart tells another.

The short-term chart shows the +DI far above -DI and the trend is strong above the 25 levels. The RSI for most of the week showed that prices were accelerating to the upside. CAT reached the oversold level and stayed around the level for most of the week with the exception of Thursday when it was oversold.

The Bull Call debit spread was deeply in the money by the third day and the Greeks took on gamma and theta that resembled a short position. The gamma turned negative meaning I needed the underlying to sit still. The theta turned positive meaning I would earn money with the passage of time.

The Greeks are important to watch and often change as volatility, time, and the underlying price change. The Greeks give you an indication of the risks and possibilities of your position. Below is a spreadsheet detailing the Greeks and other factors I monitor while in the trade:

Normally when the Greeks turned on this position, I’d have to wait to close the position near its expiration date to reach the maximum profit. However, CAT gapped up on Friday due to the positive Bank earnings reports and overall satisfaction with the deceleration in rising prices.

Expiration Date:

4/21/2023 (An option with two weeks to expiration)

Trade Type:

Bull Call Spread: Buy the 215 Call and Sell the 217.50 call

Price Paid:

$1.49

Trade Review on the day the trade was closed:

I don’t think I have encountered a trade yet that was without challenges. I saw a couple things on the chart of Catepillar (CAT) that led me to believe it could rise higher. Historical volatility was a lot higher than implied volatility. CAT was also using the 20 SMA as a resistance level. The RSI was trending upward. The ADX should that the DMI- was trending downards while the DMI+ was starting make its way up. When I entered this bull call debit spread it was pretty much profitable from the beginning. The only problem was the wide bid-ask spread. It was so wide that I couldn’t get out at the price I wanted so I had to wait.

I faced the same problem with AT&T but didn’t realize it. I was pretty much stuck with the position unless it made a large move, other wise I’d be closing the position closer to the bid which would leave me with a loss.  I wasn’t sure how this position would turn out because of the economic reports and the beginning of the earnings season with banks. For two days the position ended the day with the same profit it started with on the previous day. It was hard watching the position go in the green and being unable to closer. Lesson: Look for options with a tight bid-ask spread so that you can exit the position when needed.

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