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.
THE DECISION
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!
THE TRADE
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. http://www.amazon.com/Getting-Started-Options-Michael-Thomsett/dp/047117758X
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
(LESS) SELL CALL STRIKE @ $20.0
= $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)
CONCLUSION
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.
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