Monday, October 24, 2011

An Easy Option Strategy to Consider: Time Spreads

Today, I'd like to share one of the easiest yet most profitable strategies an option trader can make. The option strategy is called a time spread or calendar spread If you employ this strategy successfully, I only ask that you give a healthy portion of your profits to a charity or individual in need!
There are 4 reasons I believe this type of option strategy is worthwhile
1) The trade is easy to construct
2) The trade is easy to manage
3) The trade does not need to be adjusted once opened because it is "forgiving" 
4) The trade is an excellent foundation for more advanced strategies (diagonals/double)
With the above reasons in mind, the first requirement in learning time spreads is knowing how to construct them. The basic time spread is defined in  2 ways:
1) Sell a near month call and Buy a far month call having the same strike or exercise price.
     For instance, you can    Sell a November 50 call to open and
                                                     Buy a December 50 call to open the trade
This is called a call time spread. (bullish bias: believe stock will rise)
2) Sell a near month put and Buy a far month put having the same strike price.
      For instance, you can   Sell a November 50 put to open and
                                                      Buy a December 50 put to open the trade
This is called a put time spread. (bearish bias: believe stock will decline)
Either time spread is opened as a single trade.
Making the Trade:
Questions you ask yourself:
1) What underlying stock do I choose for my option time spread?
2) Once I've chosen a stock, am I bullish, bearish, or neutral on its price direction?
3) Once I've determined the direction, I then ask what option months and strike price do I choose?
4) What is my maximum risk/reward in placing the trade?
To answer these questions, let's look at an example.
Answer #1: An underlying stock that I've chosen is Lockheed Martin Corporation (LMT).  Currently, Lockheed's stock price is trading at $77.40 per share.  Lockheed, as well as most of the stock market has seen a recent rally.  However, I am of the belief that Lockheed has limited upside over the next couple of months, and do not anticipate a collapse anytime soon either.  Answer #2: So, my stance is more neutral than anything.  Given my neutral bias, I will place a put time spread trade.
Answer #3: Now I need to determine Lockheed's put option months and strike price.  October put options have already expired, so I will use the November (near month put contract with 27 days till expiration) and December (far month put contract with 55 days till expiration).  In choosing what put strikes to use, as a rule of thumb, always opt for the out-of-the-money (OTM) strikes because in-the-money (ITM) strikes exhibit larger bid ask spreads plus they run a higher risk of early assignment.  In Lockheed's case, the best OTM put strike is 75.  The 75 strike price is currently $2.40 OTM ($77.40-75).  See the LMT option chain.
With these three questions answered, we can now construct the specific put time spread trade in Lockheed Martin and then answer question 4:
Note that we are trading 5 contracts that results in a net debit of $0.98 per contract.  Time spread options always results in a net debit or payment.  $0.98 is the midpoint price difference between the December 75 option buy (ask -paid) premium price and November 75 option sell (bid -received).  So the initial total cash outlay is approximately $500.00 including trading costs.  Answer #4: The maximum gain you can obtain is approximately $678.00 if LMT trades at exactly $75 at the end of November expiration.  Obviously, the probability of that happening to the penny is not likely.  However, if you look at the profitability link, you can see that you will make money on the trade as long as LMT trades between a break even low of $71.28 and break even high of $78.58.  You begin to lose money on the trade if it breaks below or above those levels.  Should LMT explode up or plunge down, you can always exit your trade before incurring the maximum loss.  Keep in mind that the maximum loss of ~$480 doesn't occur until the stock price goes to $20 or as high as $90.00.  See profitability analysis:
Let me know if you have any questions.  Blessings to all!
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The above example was for illustrative purposes only.  Option trading involves risk and you can lose money!

Friday, September 9, 2011

Smithfield Foods (SFD) Target Price & Profit / Loss Scenarios

This is a follow-up to my previous post.  I failed to mention a possible target price on my Smithfield Foods option trade. Based on the chart below, it hits resistance at $23.13. Thus, the target exit price would preferably be around $23. However, remember this is an option trade, which has implications that are different from buying and selling stocks. For instance, assume that I keep the option position up to the January 21, 2012 expiration, and SFD is trading only $22.50 or higher. I will still receive the maximum profit on the position of $411! 

Like I said, option pricing differs considerably from its underlying stock price. For instance, stock price is a perpetual price (in theory anyways unless it is an Enron!), where an option's price has a limited life and is considered a "wasting asset". Other differences that impact an option's price are "the greeks": delta, theta, gamma, and vega.

At this point, I don't want to get into the details of the greeks. I strongly suggest reading Lawrence G. McMillan's book titled "Options as a Strategic Investment"  for a solid foundation in understanding option pricing and advanced option strategies. 

For now, just understand that option greeks and time impact an option's price.  This impact is even more pronounced for companies that have volatile stock prices.  The more volatile the underlying stock price is, the more expensive, or valuable an option's price will be simply because of its volatility. A volatile company example would be Riverbed Technology (RVBD) which has seen its stock price fluctuate in the last year from $17 to $45, back down to $20, versus a relatively stable Procter & Gamble (PG) that has remained in a stock price range between $57-$67. So where does SFD stand in terms of its volatility?  It's volatility is "in the middle" of these examples. 

Given that the SFD option position does not expire for another 497 days (January 21, 2012), you might ask "what would my profit be if SFD explodes to $23 by September 30?" Thanks to the amazing technology of today's trading platforms, you can obtain a fairly accurate estimate of profit.  I use the thinkorswim (TOS) platform for my trading purposes.  

Going to the TOS platform's "Analyze" tab you can easily obtain theoretical option pricing by changing the underlying stock price and date.  Doing this for SFD results in an estimated profit of $128 if you decide to close out of the position on September 30.  Assume you decide to close out of the trade, you would have realized 31% of the total profit potential ($128/$411).  Of course, you could decide to hold on to the position, but you also risk the price moving against you and your profit could be lost.  

On the flip side, what if SFD's stock price moves against you, say to $18.00 by September 30?  Again, you can enter the criteria in the TOS platform for an estimate. A move lower to $18 by September 30 results in an estimated loss of $141, or 42% of total possible loss ($141/$339).  Once again, a decision has to be made.  Do I think SFD is going to recover in time (by January)?  After all, the most you can lose on the trade is $339.  One of the main reasons I placed this trade further out in time was to allow for some downside risk, so for me, I would probably hold out for a longer period of time.  Doing so does risk the underlying price for further declines that may be unrecoverable.  But I am willing to take that risk.        

In conclusion, an easy, straightforward way for me to understand my vertical bull call debit spread positions are as follows:  

   --- In our SFD trade the lower strike price is JANUARY $20 (current (9/9/11) SFD Stock Price is: $19.45 

   --- In our SFD trade the higher strike price is JANUARY $22.50 (current (9/9/11) SFD Stock Price is: $19.45  

Thursday, September 8, 2011

Smithfield Foods (SFD) --- Buying Opportunity? 

Posted by: H2Options 

Today I would like to share a bit of what I do for a living as an equity options trader.  I try to find opportunities that make sense from both a fundamental and technical perspective whenever possible. 
For example, I consider my analysis of Smithfield Foods (SFD) fits this criteria.  On the fundamental side, SFD reported first quarter earnings earlier today that beat Wall Street expectations by jumping 50% to $0.69 per share, while revenue climbed 7% to $3.1B. Revenues were boosted by increased sales in the company's pork segment coupled with higher hog prices. Although Smithfield expects feed prices to continue to be elevated, the company maintains that they have sufficiently hedged its expenses for FY 2012 and sees "strong momentum" ahead. Unfortunately, SFD missed expectations on its 1Q sales by $100M, as Wall Street was looking for $3.2B.  
Given the overall strong "fundamental" case for SFD, you would think that its stock price would naturally go up today.  However, as often is the case, Wall Street looks for perfection. They often "shoot first" and ask questions later.  I believe this is what happened today with SFD.  As can be seen from the 9-month daily chart below,  SFD plunged 7.64% at the time of this writing to $20.43 per share! Looking at the chart more closely reveals a technical level that SFD reached at around $20.25 per share.  See that on August 9, 2011, SFD hit a low of $18.04.  You will notice a trend line drawn from that point through today's close.  Notice that SFD's stock price remains above the trend line for this entire period. It came close to penetrating on August 26 at $19.50 and again on September 6 at $20.18.  
As an equity options trader, I now have to make several decisions on SFD.  Do I believe in the company's fundamental prospects to gain "strong momentum" in the future quarter? Do I believe SFD's stock price will remain trending higher as its technical chart potentially  projects?  Am I willing to take a risk on SFD?  What kind of option trade should I make if I decide to "go long" SFD?  Based on the information discussed above, I decided to place an option trade on SFD!
One of the main reasons I trade equity options is due to their flexibility. I recommend reading Michael Thomsett's "Getting Started in Options" to get a better understanding of the world of options and its many strategies.
One of the strategies detailed in the book is what is called a "bull call debit spread".  I placed the following trade earlier today on SFD when the stock was trading at $20.30:  
I purchased +3 January 20 Calls for $2.35 and simultaneously sold -3 January 22.50 Calls at $1.22.  Each option contract equates to 100 shares of SFD.   So, the purchase of 3 January 20 calls is simply 3 x 100 x $2.35 = $705.  Similarly, I sold 3 January 22.50 calls: 3 x 100 x $1.22 = $366.  Taking the $705 purchase less the $366 received leaves $339.  $339 is the maximum loss you could have on the trade.  The maximum gain you can attain is $411.  (Keep in mind this example does not include trading costs).  Below I show the mechanics of the trade...
BUY CALL STRIKE @                  $22.5  
=                                                               $2.50  
(LESS) NET DEBIT                          $1.13  (Buy Premium $2.35 less Sell Premium $1,22)
 MAXIMUM RISK =                         $1.37 
 x # CONTRACTS                                     3 
 x # SHARES @                                       100 
 MAX $ RETURN =                      $411.00 (MAX Risk $1.37 x 3 Contracts x 100 shares)
 MAX % RETURN =                         121.2% (MAX Risk $1.37/Net Debit $1.13)
 MAX $ RISK =                               $339.00 (Net Debit $1.13 x 3 Contracts x 100 shares)
 BREAKEVEN STOCK PRICE = $21.13 (Buy Call Strike $22.5- MAX Risk $1.37)

I like this particular trade set up because of the flexibility it gives me. I know what my maximum risk and reward is.  It also gives me sufficient time, in case the trade initially works against me as the option does not expire until January 2012.  Keep in mind, I can also close the trade at any time before option expiration and realize whatever profit or loss that may occur.
Twitter: H2Options
DISCLAIMER: This information is for illustrative purposes only!  Option trading involves substantial risks. The performance of, or any investment is not guaranteed. Past investment performance is not indicative of future investment performance. The value of investments and the income from them can fall as well as rise and are not guaranteed. You may not get back the amount originally invested.

Saturday, September 3, 2011

Sell in May and Go Away...Time to Come Back?

Earlier this year I thought I would for once follow the rest of the "big money" adage of "Sell in May and go away".  As it turned out, this wound up being a wise move. Take a look at the weekly chart of SPX from the 3/2/09 low of ~666 to the breaking of the uptrend ~1300 on 5/31/11.  Note that in May of 2010, a sell off occurred then too, but did not break the upward trend. We made a couple of attempts to re-establish the upward bias in late June 2011 and early July only to fall off considerably for most of August.  Now that September has arrived, we've seen additional selling, giving back a good portion of some late August portfolio manager "window dressing". The technical picture certainly reveals a broken market. Question is, will the slide continue?  The macro fundamentals are certainly worrisome...stubbornly high US unemployment, the euro mess, China slowing, etc. Yet most companies continue to deliver on earnings and grow their markets in spite of all the world's problems. Many think this is about to change, as the macro picture will eventually dim company prospects going forward. Growing concern over what Merkel and Van Rompuy will say on Monday regarding the euro-zone debacle has many believing this will really put our global markets in a tailspin. Don't forget to throw in President Obama's job speech on Thursday for good measure.  Doom and gloom pundits are certainly coming out in droves, and why not, given the continued rise in gold and silver prices while our currencies weaken. The world as we know it may indeed be coming to an end very soon. But another part of me continues to think about what the "big money" guys and gals are going to do. After all they should be returning from the Hampton's next week! I would not be surprised that the markets take a dive this coming week, while the "big money" is quietly waiting to "pull the trigger" for some spectacular buys.  We shall see. 

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