Have you ever been cautiously bullish on a stock, but found premiums too expensive to consider an outright purchase? Or perhaps, maybe you know there’s still very real downside gap risk involved due to potential problems caused by either management or market forces and therefore consider a Long Call purchase too rich on that basis? Worse yet, both conditions exist, but you still find yourself compelled to search for the right type of strategy. If that’s the case and without getting into the particulars over whether contrarian positioning is appropriate or not; traders might look to the Bull Call or Put Vertical as a solution.

These days of course traders need look no further than most financial stocks if they’re interested in positioning for the proverbial bottom. Stocks like Citigroup () and Merrill Lynch () and possibly less known companies such as MGIC Investments (), Landamerica Financial Group () or nameless others with credit-related risks have been hitting multi-year lows. Additionally, with very sour sentiment and fresh risks / losses popping up virtually every day; the group as a whole fits the mold of the classic contrarian play.

Stocks like the fore-mentioned can pose a couple of problems though, for any would-be bulls. First, for limited risk strategists the implieds or premiums to purchase a Long Call are through the roof. That makes bets on positions much more difficult to justify on a theoretical, as well as a real world basis. In fact, should the trader be so lucky as to find the stock moving in the right direction, if it occurs as the bearish story line drops out of favor, premiums could drop rapidly and counter all but the most extremely bullish outcomes in the stock.

For instance, in the case of Merrill “Lynched”, checking the board late in the session, premiums exploded higher for a second straight session. As this action relates to the November Calls, the implieds have jumped by 70% from 40% I.V. to roughly 70% I.V. With two trading weeks left that type of “juice” becomes very costly if the timing is just slightly off and / or barring a counter and helpful catalyst as time decay becomes a very real concern.

With MER between Strikes currently, purchasing the OTM November 60’s costs 2.15 using the mid-market price. With shares at 57.28, Theta of 0.11 a day and growing larger, hopefully traders see the odds as being stacked up against this type of position in of itself. Secondly, there’s always the risk the story doesn’t get better and someone like your chosen “Anchor Banker” finds itself sailing further down river. And if it occurs on a gap, those dreamy Calls will be punishing on the trading account to say the least.

At the same time and without making a recommendation as to the appropriateness of this style of investing, more effective positioning can be made possible with the Bull Vertical using either Calls or Puts. Again, using Merrill for illustrative purposes, if a trader instead focuses on a Vertical spread, an all-around stronger position, which takes some of the “hopeful and wishful” thinking out of the equation, can be constructed. For instance, for a slightly higher debit of 2.55, the Nov 55 / 60 virtually eliminates the fore-mentioned Theta risk at current levels. Additionally, the downside risk is actually reduced under all, but the most severe price moves, since that spread owns the lower Strike. Sure, the Bull Vertical will reduce the contrarian’s potential upside, but speaking practically while enjoying the theoretical possibilities; that’s a good problem to have over the long haul versus the potential alternative.

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The observations provided are not investment advice or a recommendation, the suitability of which is considered the responsibility of the trader.

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