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Call Spreads in Crazytown - INO, NKLA, PENN etc.
3 min read

Call Spreads in Crazytown - INO, NKLA, PENN etc.

Call Spreads in Crazytown - INO, NKLA, PENN etc.

Overview

There's been much talk lately about small retail's effect on some small cap stocks. Short squeezes, wild swings, Barstool Sports, you've heard it by now. While the debate can rage on the historical significance of what we're seeing and how it ends, we're more interested in it's effect on options pricing and how to take advantage

Earlier in June we looked at Nikola (NKLA) and the opportunity that reverse skew in the options provided to the upside. That's not a call that NKLA was going to go higher, it's more that, the odds being provided on vertical call spreads becomes extraordinary (compared to stock or calls outright) if one was still bullish. You can read that post here.

There are a bunch of these type of stocks in the market right now. And it's more than likely the music will stop soon. But from an options perspective, a better use of funds than buying these stocks or buying calls exists.

The Set-up

Here's an example in one of the story stocks, Penn National (PENN). Observe the difference in probability being assigned by the options market for a move 20% higher in the stock and 20% lower, from Options AI technology:

As you can see, options are pricing a stock move higher at a substantially higher probability than one lower. That does not mean the stock is more likely to go higher, it's saying you need to pay more for it in options, because so many other traders are buying upside calls.

Each of these stocks are unique. Some are hard to borrow, which causes a massive vol skew between calls and puts, even on the same strike. Other have large reverse upside skew, where out of the money calls have been bid up to such an extent that they make no sense, and others everything is such super high vol that everything is overpriced.

So how does one take advantage of that? On a simple level, if you are bullish, by not buying the stock or buying calls, but rather, buying call spreads.

Ways To Play

Here's an example in story stock Inovio (INO) which is up 24% on the day! Using OptionsAI technology let's look at some trades in July:

One caveat on any multi leg trade, but particularly in a stock like this, you want to stick to expirations with some liquidity. I selected the monthly 7/17 rather than any weeklies so that there was more liquidity.

As you can see I pause on the prices of the legs of the July 30/38 call spread. The at the money 30 call is $8, the 38 call, up 26% in the stock is $6! There are people buying those calls for $6. They really shouldn't be.

Let's look at it from a breakeven perspective. The 38 calls, for $6 break even at 44. The 30 calls for $8 breakeven at $38. That's a big difference. But what's really a big difference is if you buy the 30 call and then sell the 38 call, you get a breakeven of $32:

That's a 3 to 1 payout if the stock goes to 38 or above, and only needs the stock to be above 32 on expiration to breakeven. The 60% probability of profit is a reflection of the options market, not the breakeven itself which is obviously under 50%. But 32 is close enough that it's basically a coin flip, but in this case a coin flip with potential to make 3 times the money.

Summary

Again this is not to make a bullish case for any of these stocks. I'm sure 90% of them will end in tears in a few months. But man, if you're gonna do it, do it right. For those buying up these stocks, or buying up these out of the money calls, there's a smarter way to trade them.

Previously:

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