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.

The 4 Primary Option Greeks are:

Delta (Greek Symbol δ) - a measure of an option's sensitivity to changes in the price of the underlying asset 

Gamma (Greek Symbol γ) - a measure of delta's sensitivity to changes in the price of the underlying asset 

Vega - a measure of an option's sensitivity to changes in the volatility of the underlying asset 

Theta (Greek Symbol θ) - a measure of an option's sensitivity to time decay 
  

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"  http://www.amazon.com/Options-Strategic-Investment-Lawrence-McMillan/dp/0735201978  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:  

MAXIMUM RISK (LOSS) CAN OCCUR IF THE UNDERLYING STOCK PRICE FALLS BELOW THE LOWER CALL STRIKE PRICE

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

MAXIMUM GAIN CAN OCCUR IF THE UNDERLYING STOCK PRICE IS ABOVE THE HIGHER CALL STRIKE PRICE

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