Filling the Gap with a Long Call Spread

During the COVID crisis the stock market declined, but energy stocks were particularly hard hit as the price of oil plunged to levels never before seen.  During the panic selling, one of Canada’s largest energy companies, Suncor Energy (ticker SU) left a gap from $33.52 to $30.19. (A down gap is where the price opens on the next day lower than the previous day’s close.) 

Chart 1: Suncor Energy (symbol SU) 2019-2020

Source: Bloomberg

Many traders watch unfilled gaps closely, believing that eventually they will all be filled (meaning that the price will trade up or down to levels that it had previously gapped through).

A trader who believes in this theory could simply buy the stock and wait for the gap to fill.  However, sometimes it takes a long time for the rally to develop (as evidenced by Suncor’s recent action).

Another alternative is for a trader to purchase a debit call spread (a.k.a. a bull call spread) that will deliver a profit if the gap is filled. 

To implement a debit call spread, a trader buys a call option with one strike while simultaneously selling a call option with a higher strike.

Source: The Montréal Exchange – link https://www.m-x.ca/f_publications_en/strategy_bull_call_spread_en.pdf

The nice thing about this strategy is that it enables the trader to profit from a specific stock price path.  In this particular case, we can use a debit call spread to express the view that Suncor Energy will trade up to $33.52 to fill the gap left during the COVID market crisis.

Suncor Energy has option series extending all the way to January 2023, but we will focus on the January 2022 series.

Here are the quotes for the options we are interested in:

(As of 09/25/20)

Mid-price (middle of the spread) execution equals $0.17 ($0.65 – $0.48), but it is not realistic to expect the orders to be filled at this level.  However, it would not be unreasonable to expect to be filled $0.03 higher, at a debit of around $0.20.

Execution prices might look something like this:

Investor BUYS 10 SU 1/21/22 $30 Strike Calls @ $0.66

Investor SELLS 10 SU 1/21/22 $34 Strike Calls @ $0.46

The net debit to the investor is $0.20 ($0.66 minus $0.46).

If we were to buy 10 contracts of this spread, it would mean an outlay of $200.  This would be the most at risk if, during the ensuing 484 days, Suncor did not fill the gap.

However, if Suncor did manage to rally back to that level, the spread would be worth $2,000, resulting in a gain of $1,800. 

Debit call spreads are an interesting (and less costly) method for expressing views that specific price levels will be reached.  They can be just the ticket for traders who believe that unfilled gaps are magnets that will eventually attract the stock back up to that price level.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.