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Posts Tagged ‘diagonal spreads’

Maybe it’s Time to Buy Options Rather Than Sell Them

Monday, June 23rd, 2014

Last week I recommended buying a calendar spread on SVXY to take advantage of the extremely high option prices for the weekly options (at-the-money option prices had more than doubled over the past two weeks).  The stock managed to skyrocket over 7% for the week and caused the calendar spread to incur a loss.  When you sell a calendar spread, you want the stock to be trading very close to the strike price when the short options expire.  When the underlying stock makes a big move in either direction, you generally lose money on these spreads, just as we did last week.

Ironically, this spread was the only losing portfolio out of the 10 portfolios we carry out at Terry’s Tips (ok, one other portfolio lost a couple of dollars, but 8 others gained an average of almost 5% for the week).  The only losing spread was the one I told the free newsletter subscribers about.  Sorry.  I’ll try to do better next time.

Terry

Maybe it’s Time to Buy Options Rather Than Sell Them:

Option prices are almost ridiculously low.  The most popular measure of option prices is VIX, the so-called “fear index” which measures option prices on SPY (essentially what most people consider “the” market).  Last week VIX fell almost 11% to end up below 11.  The historical mean is over 20, so this is an unprecedented low value.

When we sell calendar or diagonal spreads at Terry’s Tips, we are essentially selling options to take advantage of the short-term faster-decaying options.  Rather than using stock as collateral for selling short-term options we use longer-term options because they tie up less cash.

With option prices currently so low, maybe it is a time to reverse this strategy and buy options rather than selling them.  On Friday, in the portfolio that that lost money on the SVXY calendar spread, we bought at-the-money calls on SPY  for $1.36.  It seems highly likely that  the stock will move higher by $1.50 or more at some point in the next 3 weeks and make this a winning trade (SPY rose $1.81 last week, for example).

With option prices generally low across the board and the stock market chugging consistently higher in spite of the turmoil in Iraq, maybe this would be a good time to buy a call option on your favorite stock.  Just a thought.

An Interesting Trade to Make on Monday

Monday, June 16th, 2014

The recent developments in Iraq have nudged options volatility higher, but for one underlying, SVXY, it has apparently pushed IV through the roof.  This development has brought about some potentially profitable option spread possibilities.Terry

An Interesting Trade to Make on Monday

In case you don’t know what SVXY is, you might check out the chart of its volatility-related inverse, VXX.  This is the ETP many investors use as a protection against a market crash.  If a crash comes along, options volatility skyrockets, taking VXX right along with it.  The only problem with VXX is that over time, it is just about the worst investment you could imagine making.  Three times in the last five years they have had to engineer 1 – for – 4  reverse splits to keep the price higher enough to bother with buying.  Over the past 7 years, VXX has fallen from a split-adjusted price over $2000 to its current $32.

Wouldn’t you like to buy the inverse of VXX?  You can.  It’s called SVXY  (XIV is also its inverse, but you can’t trade options on XIV).

Last week I talked about buying short-term (weekly) call options on SVXY because in exactly half the weeks so far in 2014, the stock had moved $4 higher at least once during the week.  I also advised waiting until option prices were lower before taking this action.  Now that option prices have escalated, the best thing seems to be selling option premium rather than buying it.

Two weeks ago, a slightly out-of-the-money weekly SVXY option had a bid price of $1.05.  Friday, that same option had a bid price of $2.30, more than double that amount.

All other things being equal, SVXY should move higher each month at the current level of Contango (6.49%).  That works out to about $1.20 each week.  I would like to place a bet that SVXY moves higher by about that amount and sell a calendar spread at a strike price about that much above Friday’s close ($79.91).

Below I have displayed the risk profile graph  for a July-June 81 calendar put spread (I used puts rather than calls because if the stock does move higher, the June puts will expire worthless and I will save a commission by not buying them back.

This would be the risk profile graph if we were to buy 5 Jul-14 – Jun-14 put calendar spreads at the 81 strike price at a cost of $3.00 (or less).  You would have $1500 at risk and could make over 50% on your investment if the stock goes up by amount that contango would suggest.  Actually, as I write this Monday morning, it looks like SVXY will open up about a dollar lower, and the spread might better be placed at the 80 strike instead of the 81.

SVXY Risk Profile Graph June 2014
SVXY Risk Profile Graph June 2014

A break-even range of $3 to the downside and about $5 on the upside looks quite comfortable.  If you had a little more money to invest, you might try buying September puts rather than July – this would allow more time for SVXY to recover if it does fall this week on scary developments in Iraq (or somewhere else in the world).

I have personally placed a large number of Sep-Jun calendar spreads on SVXY at strike prices both above and below the current stock price in an effort to take advantage of the unusually higher weekly option prices that exist  right now.

That’s enough about SVXY for today, but I would like to offer you a free report entitled 12 Important Things Everyone with a 401(K) or IRA Should Know (and Probably Doesn’t).  This report includes some of my recent learnings about popular retirement plans and how you can do better.  Order it here.  You just might learn something (and save thousands of dollars as well).

How Option Prices are Determined

Monday, April 21st, 2014

Last week was one of the best for the market in about two years.  Our option portfolios at Terry’s Tips made great gains across the board as well.  One portfolio gained 55% for the week, in fact.  It is fun to have a little money tied up in an investment that can deliver those kinds of returns every once in a while.

This week I would like to discuss a little about what goes into an option price – what makes them what they are?

Terry

How Option Prices are Determined

Of course, the market ultimately determines the price of any option as buyers bid and sellers ask at various prices.  Usually, they meet somewhere in the middle and a price is determined.  This buying and selling action is generally not based on some pie-in-the-sky notion of value, but is soundly grounded on some mathematical considerations.

There are 5 components that determine the value of an option:

1. The price of the underlying stock

2. The strike price of the option

3. The time until the option expires

4. The cost of money (interest rates less dividends, if any)

5. The volatility of the underlying stock

The first four components are easy to figure out.  Each can precisely be measured.  If they were the only components necessary, option pricing would be a no-brainer.  Anyone who could add and subtract could figure it out to the penny.

The fifth component – volatility – is the wild card.  It is where all the fun starts.  Options on two different companies could have absolutely identical numbers for all of the first four components and the option for one company could cost double what the same option would cost for the other company.  Volatility is absolutely the most important (and elusive) ingredient of option prices.

Volatility is simply a measure of how much the stock fluctuates.  So shouldn’t it be easy to figure out?   It actually is easy to calculate, if you are content with looking backwards.  The amount of fluctuation in the past is called historical volatility.  It can be precisely measured, but of course it might be a little different each year.

So historical volatility gives market professionals an idea of what the volatility number should be.  However, what the market believes will happen next year or next month is far more important than what happened in the past, so the volatility figure (and the option price) fluctuates all over the place based on the current emotional state of the market.

Using Puts vs. Calls for Calendar Spreads

Monday, April 7th, 2014

I like to trade calendar spreads.  Right now my favorite underlying to use is SVXY, a volatility-related ETP which is essentially the inverse of VXX, another ETP which moves step-in-step with volatility (VIX).  Many people buy VXX as a hedge against a market crash when they are fearful (volatility, and VXX. skyrockets when a crash occurs), but when the market is stable or moves higher, VXX inevitably moves lower.  In fact, since it was created in 2009, VXX has been just about the biggest dog in the entire stock market world.  On three occasions they have had to make 1 – 4 reverse splits just to keep the stock price high enough to matter.

Since VXX is such a dog, I like SVXY which is its inverse.  I expect it will move higher most of the time (it enjoys substantial tailwinds because of something called contango, but that is a topic for another time).  I concentrate in buying calendar spreads on SVXY (buying Jun-14 options and selling weekly options) at strikes which are higher than the current stock price.  Most of these calendar spreads are in puts, and that seems a little weird because I expect that the stock will usually move higher, and puts are what you buy when you expect the stock will fall.  That is the topic of today’s idea of the week.

Terry

Using Puts vs. Calls for Calendar Spreads

It is important to understand that the risk profile of a calendar spread is identical regardless of whether puts or calls are used.  The strike price (rather than the choice of puts or calls) determines whether a spread is bearish or bullish.  A calendar spread at a strike price below the stock price is a bearish because the maximum gain is made if the stock falls exactly to the strike price, and a calendar spread at a strike price above the stock price is bullish.

When people are generally optimistic about the market, call calendar spreads tend to cost more than put calendar spreads.  For most of 2013-14, in spite of a consistently rising market, option buyers have been particularly pessimistic.  They have traded many more puts than calls, and put calendar prices have been more expensive.

Right now, at-the-money put calendar spreads cost more than at-the-money call calendar spreads for most underlyings, including SVXY.  As long as the underlying pessimism continues, they extra cost of the put spreads might be worth the money because when the about-to-expire short options are bought back and rolled over to the next short-term time period, a larger premium can be collected on that sale.  This assumes, of course, that the current pessimism will continue into the future.

If you have a portfolio of exclusively calendar spreads (you don’t anticipate moving to diagonal spreads), it is best to use puts at strikes below the stock price and calls for spreads at strikes which are higher than the stock price.  If you do the reverse, you will own a bunch of well in-the-money short options, and rolling them over to the next week or month is expensive (in-the-money bid-asked spreads are greater than out-of-the-money bid asked spreads so you can collect more cash when rolling over out-of-the-money short options).

How to Play War Rumors

Monday, March 10th, 2014

Last week, on Monday, there were rumors of a possible war with Russia.  The market opened down by a good margin and presented an excellent opportunity to make a short-term gain.  Today I would like to discuss how we did it at Terry’s Tips and how you can do it next time something like this comes along.

Terry

How to Play War Rumors

When the market opens up at a higher price than the previous day’s highest price or lower than the previous day’s lowest price, it is said to have a gap opening.  Gap openings unusually occur when unusually good (or bad) news has occurred.  Since there are two days over which such events might occur on weekends, most gap openings happen on Mondays.

A popular trading strategy is to bet that a gap opening will quickly reverse itself in the hour or two after the open, and day-trade the gap opening.  While this is usually a profitable play even if it doesn’t involve the possibility of a war, when rumors of a war prompted the lower opening price, it is a particularly good opportunity.

Over time, rumors of a new war (or some other economic calamity) have popped up on several occasions, and just about every time, there is a gap (down) opening. This time, the situation in Ukraine flared, even though any reasonable person would have figured out that we were highly unlikely to start a real war with Russia.

When war rumors hit the news wires, there is a consistent pattern of what happens in the market.  First, it gaps down, just like it did on Monday.  Invariably, it recovers after that big drop, usually within a few days.  Either the war possibilities are dismissed or the market comes to its senses and realizes that just about all wars are good for the economy and the market.  It is a pattern that I have encountered and bet on several times over the years and have never lost my bet.

On Monday, when the market gapped down at the open (SPY fell from $186.29 to $184.85, and later in the day, as low as $183.75), we took action in one of the 10 actual portfolios we carry out for Terry’s Tips paying subscribers (who either watch, mirror, or have trades automatically placed in their accounts for them through Auto-Trade).

One of these portfolios is called Terry’s Trades.  It usually is just sitting on cash.  When a short-term opportunity comes along that I would do in my personal account, I often place it in this portfolio as well.  On Monday, shortly after the open, we bought Mar2-14 weekly 184 calls on SPY (essentially “the market”), paying $1.88 ($1880 plus $12.50 commissions, or $1900.50) for 10 contracts.  When the market came to its senses on Tuesday, we sold those calls for $3.23 ($3230 less $12.50 commission, or $3217.50), for a gain of $1317, or about 70% on our investment.  We left a lot of money on the table when SPY rose even higher later in the week, but 70% seemed like a decent enough gain to take for the day.

War rumors are even more detrimental to volatility-related stocks.  Uncertainty soars, as does VXX (the only time this ETP goes up) while XIV and SVXY get crushed.  In my personal account, I bought SVXY and sold at-the-money weekly calls against it.  When the stock ticked higher on Friday, my stock was exercised away from me but I enjoyed wonderful gains from the call premium I had sold on Monday.

Whether you want to bet on the market reversing or volatility receding, when rumors of a war come along (accompanied by a gap opening), it might be time to act with the purchase of some short-term near-the-money calls.  Happy trading.

Legging Into a Short Iron Condor Spread

Monday, March 3rd, 2014

Today I would like share with you the results of an actual trade recommendations I made for my paying subscribers on January 4th of this year and how subsequent price changes have opened up option possibilities that can further improve possibilities for a first investment.

Please don’t get turned off by what this new spread is called.

Terry

Legging Into a Short Iron Condor Spread

In my weekly Saturday Report that I send to paying subscribers, on January 4, 2014 I set up an actual demonstration portfolio in a separate trading account at thinkorswim in which I made long-term bets that three underlying stocks (GOOG, SPY, and GMCR) would be higher than they currently were at some distant point in the future.  The entire portfolio would make exactly 93% with the three spreads I chose if I were right about the stock prices.

Almost two months later, things are looking pretty good for all three spreads, but that is not as important as what we can learn about option possibilities.

If you recall, early this year I was quite bullish on Green Mountain Coffee Roasters (GMCR) which has recently changed their name to Keurig Green Mountain.  The major reason was that three insiders who had never bought shares before had recently made huge purchases (two of a million dollars each).  I Googled these men and learned that they were mid-level executives who were clearly not high rollers.  I figured that if they were committing this kind of money, they must have had some very good reason(s),  Also, for four solid months, not a single director had sold a single share, something that was an unusual pattern for the company.

My feelings about the company were also boosted when a company writing for Seeking Alpha published an article in which they had selected GMCR as the absolute best company from a fundamental standpoint in a database of some 6000 companies.

This is what I wrote in that Saturday Report – “The third spread, on Green Mountain Coffee Roasters (GMCR), is a stronger bullish bet than either of the first two, for two reasons.  The stock is trading about in the middle of the long and short put prices (70 and 80), and the time period is only six months (expiring in June 2014) rather than 11 or 12 months.  I paid $540 for the Jun-14 80 – Jun-14 70 vertical put credit spread.  My maximum loss is $460 per spread if the stock closes below $70, and I will make 115% after commissions in six months if it closes above $80.”

This vertical put credit spread involved selling the Jun-14 80 puts for $13.06 and buying the Jun-70 puts for $7.66, collecting $540 for each spread.  I sold 5 of these spreads, collecting a total of $2700.  There would be a maintenance requirement of $5000 for the spreads (not a margin loan which would have interest charged on it, but an amount that I couldn’t use to buy other stocks or options).  Subtracting what I received in cash from the maintenance requirement, my real cost (and maximum loss) would be $2300.  If GMCR closed at any price above $80 on June 21, 2014, both puts would expire worthless and I could keep my $2700 and make 115% after commissions (there would be no commissions to pay if both puts expired worthless).

An interesting side note to the $2700 cash I received in this transaction.  In the same account, I also owned shares of my favorite underlying stock.  I am so bullish on this other company (which is really not a company at all, but an Exchange Traded Product (ETP)) that I owned some on margin, paying 9% on a margin loan.  The cash I received from the credit spread was applied to my margin loan and reduced the total on which I was paying interest.  In other words, I was enjoying a 9% gain on the spread proceeds while I waited out the six months for the options to expire.

In case you hadn’t heard, GMCR announced on February 5th that they had executed a 10-year contract with Coke to sell individual cups on an exclusive basis.  The stock soared some 50%, from $80 to over $120.  In addition, Coke bought 10% of GMCR for $1.25 billion, and gained over $600 million on their purchase in a single day.  Obviously, those insiders knew what they were doing when they made their big investments last November.

Now I am in an interesting position with this spread.  It looks quite certain that I will make the 115% if I just sit and wait another 4 months.  The stock is highly unlikely to fall back below $80 at this point.  I could but back the spread today for $.64, ($320 for the 5 spreads) and be content with a $2380 gain now rather than $2700 in June.

But instead, I decided to wait it out, and add a twist to my investment.  Since the deal with Coke will not reach the market until at least 2015, it seems to me that we are in for a period of waiting until the chances of success for single servings of Coke are better known.  The stock is probably not going to move by a large amount in either direction between now and June.

With that in mind, I sold another vertical credit spread with June options, this time using calls.  I bought Jun-14 160 calls and sold Jun-14 150 calls and collected $1.45 ($725 less $12.50 commissions).  These options will expire worthless if GMCR is at any price below $150 on June 21, 2014, something that I believe is highly likely.  I think it has already taken the big upward move that it will take this year.

If the stock ends up at any price between $80 and $150, I will make money on both spreads that I sold.  Now the total I can gain is $3400 (after commissions) and my net investment has now been reduced to $1600 and my maximum gain is 212% on my money at risk.

This new spread will not have any maintenance requirement because the broker understands that I can’t lose money on both vertical spreads I have sold.  He will look at the two spreads and notice that the difference between the long and short strike prices is 10 for both spreads.  As long as he is setting aside $5000 in a maintenance requirement on the account, he knows that I can lose that maximum amount on only one of the two spreads.

What I have done is to leg into what is called a short iron condor spread (legging in means you buy one side of a spread to start, and then add the other side at a later time – the normal way to execute a spread is to execute both sides at the same time).  You don’t have to know any more about it than know its name at this time, but I invite you to become a Terry’s Tips Insider and learn all about short iron condors as well as many other interesting options strategies.

Another Interesting Options Bet on Google

Monday, February 24th, 2014

Just over two months ago, shortly before Christmas, I suggested that you might consider making a bet that Google (GOOG) would be higher in one year than it was then.   I figured the chances were pretty good that it might move higher because it had done just that in 9 of its 10 years in existence.

I made this bet in my personal account and also in a real account for Insiders at Terry’s Tips to follow, or mirror in their own accounts.  The stock has moved up by about $90 since then and the bet is looking like it might pay off.

Today I would like to discuss either taking a profit early or doing something else with Google if you feel good about the company as I do.

Terry

Another Interesting Options Bet on Google

In my January 4, 2014 Saturday Report sent to Terry’s Tips Insiders, I set up a new demonstration actual portfolio that made long-term bets on three underlying stocks that I believe would be higher well out in the future than they were then.  This is what I said about one of them – “The most interesting one, on Google, will make just over 100% on the money at risk if Google is trading at $1120 or higher on January 17, 2015, a full year and two weeks from now.  It was trading at $1118 when we placed the spread, buying Jan-15 1100 puts and selling Jan-15 1120 puts for a credit of $10.06.  The stock fell to $1105 after we bought the spreads, so you may be able to get a better price if you do this on your own next week.

GOOG has gained in 9 of the 10 years of its existence, only falling in the market-meltdown of 2007.  If you were to make 100% in 9 years and loss 100% in the tenth year, your average gain for the ten-year period would be 80%.  That’s what you would have made over the past 10 years.  If the next 10 years shows the same pattern, you would beat Las Vegas odds by quite a bit, surely better odds than plunking your money down on red or black at the roulette table.

I have told many friends about this bet on Google, and most of them said they would not do it, even if they had faith in the company.  The fear of losing 100% of their investment seemed to be greater than the joy of possibly making an average of 80% a year.  I told them that the trick would be to make the bet every year with the same amount, and not to double down if you won in the first year.  But that did not seem to sway their thinking.  I find their attitude most interesting.  I am looking forward to 10 years of fun with the spread.  It is a shame that it will take so long for the wheel to stop spinning, however.

It is now almost two months later and Google’s latest earnings announcement has suggested that the company has continued to be able to monetize its Internet traffic better than anyone else, especially the social media companies who are drawing most of the market’s attention.  GOOG (at $1204) is trading almost $100 higher than it was when I wrote that report and sold that vertical put credit spread.

In the demonstration portfolio account, I had sold 5 of those vertical put spreads, collecting $10.06 ($5030 for 5 spreads) and there was a $10,000 maintenance requirement charged (no interest like a margin loan, just a claim on cash that can’t be used to buy other stocks or options).  My net investment (and maximum loss would be the maintenance requirement less the amount I received in cash, or $4970).

With the stock trading so much higher, I could now buy the spread back for $7.20 and pick up a gain of $1430.  It is tempting to take a 28% profit after only two months, but I like the idea of hanging on for another 10 months and making the full 100% that is possible.  Now I am in the comfortable position of knowing I can make that 100% even if the stock falls by $84 over that time.

Rather than taking the gain at this time, I am more tempted to buy more of these spreads.  If I could sell them for $7.20 my net investment would be $12.80 and I could make 39% on my money as long as GOOG doesn’t fall by more than $84 in 10 months.  This kind of return is astronomical compared to most investments out there, especially when your stock can fall by so much and you still make that high percentage gain.

Even better, since I continue to like the company, I am planning to sell another vertical put credit spread for the Jan-15 option series.  Today, I will buy Jan-15 1110 puts and sell Jan-15 1140 puts, expecting to receive about $11 ($1100) per spread.  My maximum loss and net investment will be $1900 and if GOOG manages to close above $1140 ($64 below its current level) on January 21, 2015, I will make 57% on my investment after commissions.

I like my odds here, just as I did when I made the earlier investment on Google.  I believe that many investors should put a small amount of their portfolio in an option investment like this, just so they can enjoy an extraordinary percentage gain on some of their money.  And it is sort of fun to own such an investment, especially when it seems to be going your way, or if not exactly going your way, at least not too much in the other direction.

Follow-Up on Green Mountain Coffee Roasters

Monday, February 10th, 2014

Twice in the past three weeks I told everyone why I was bullish on Green Mountain Coffee Roasters (GMCR) and how I was playing the options prior to their earnings announcement last week.

If anyone noticed, the stock is trading about 40% higher now after the company announced a 10-year deal with Coke for selling single portions of Coke.

This was one of those sad times where I was right but didn’t make very much money from the great news, however.  Such is sometimes the plight of owning options.  Almost anything can happen, depending on what kind of a spread you put on.

Enjoy the discussion of three kinds of option spreads.

Terry

Follow-Up on Green Mountain Coffee Roasters

This is what I wrote two weeks ago – “I bought a diagonal call spread, buying GMCR Jun-14 70 calls and selling Feb1-14 80 calls.  The spread cost me $9.80 at a time when the stock was trading at just below $80.  If the stock moves higher, no matter how high it goes, this spread will be worth at least $10 plus the value of the time premium for the 70 call with about 5 months of remaining value, no matter how much IV might fall for the June options. The higher the stock might soar, the less I would make, but I expect I should make at least 20% on my money (if the stock moves higher) in 17 days.”

While the spread could not lose money no matter how high the stock might go, this was not a great investment to make if you were as bullish on the company as I was.  The more it rose above $80, the less it would make.  A 40% move on an earnings announcement is highly unusual, but that is what happened.

When the stock traded down a bit last Friday, I sold that spread for $11.00, making $1.20 less commissions of $.05, or $1.15 ($115 per spread).  That worked out to about 12%.  I will never complain about making a gain, but this was a major disappointment when I was so right about how the stock would move after the announcement.  It just moved a whole lot more than I expected.

Last week I told you about another spread I placed on GMCR before earnings.  This was a calendar spread (same strike, buy one further-out month and sell a shorter-term option).  The trick was to pick the strike price you believed the stock would end up after the announcement.  With the stock trading at $80 before the announcement, I suggested to pick the 85 strike (buying April calls and selling March calls for about $.80 per contract).

The further away from $85 the stock traded after the announcement, the less well the calendar spread would do.  On the other hand, if you correctly picked the price, you could make 200% or more on your money.  When the stock soared $30 and was trading around $110, this spread lost about half its value (I actually bought 100 of these spreads at the 90 strike instead of the 85 strike, but this spread did not do much better – I am hanging on to most of the contracts just in case it reverses direction over the next 6 weeks).

Another spread which I did not report to everyone (except my paying subscribers) was a vertical put credit spread, selling 85 puts and buying 75 puts in the same month.  I placed these trades for June, collecting a credit of $5.20, making my investment $480 per spread (this is the amount that would be my maximum loss if GMCR closes below $75 in June).  If the stock closes above $85 (which it looks highly likely to do), I will make 108% on my investment.  (I also sold similar vertical put credit spreads for both March and June at others strikes, and every spread appears that it will make 70% or better at expiration).

This time around, the calendar spreads didn’t fare well because the stock skyrocketed so high.  It is really necessary to guess where the stock will end up with that kind of spread.  I was too conservative in my bullishness. Who would have ever guessed that the stock would soar by 40%?  Certainly not me.  But I was happy that I also bought some other directional spreads that profited from the upward move (these spreads would have done just as well, or better, if the upward stock price move had been smaller).

An Interesting Calendar Spread Play

Wednesday, February 5th, 2014

Today after the close, one of my favorite stocks, Green Mountain Coffee Roasters (GMRC) , announces earnings.  I am taking quite a chance telling you about another option spread investment that I made this week because if the stock tanks after today’s announcement, I won’t be looking so good.The idea I am suggesting can be used for any stock you might have an opinion about, and it could easily double your money in about six weeks if you are approximately right about where the stock might be at that time.

Terry

An Interesting Calendar Spread Play

As you probably know, I love calendar spreads.  These spreads involve buying a longer-out option and selling a shorter-length option at the same strike price.  You only have to come up with the difference between the two option prices when you place the order.

When the short options expire, if the stock is very close to the strike price of your spread, you can expect to sell the spread for a great deal more than you paid for it.The further away from the strike price the stock is when the short options expire, the less valuable the original spread will be.

The trick is guessing where the stock might end up when the short options expire. This takes a little luck since no one really knows what any stock is likely to do in the short run.  But if it’s a stock you have followed closely, you might have an idea of where it is headed.

I happen to like GMCR.  I like knowing that insiders have bought millions of dollars worth of stock in the past few months and 30% of the stock has been sold short (a short squeeze could push the stock way up).  So I am guessing that the stock will be closer to $85 in six weeks compared to $80 where it closed yesterday (as I write this Wednesday morning it has moved up to about $81.50).

I bought a calendar spread on GMCR at the 85 strike, buying Apr-14 calls and selling Mar-14 calls.  I paid $.85 ($85) per spread for 10 spreads, shelling out $850 plus $25 in commissions.  Here is the risk profile graph for March 22 when the short options expire:

GMCR calendar risk profile graph feb 2014

GMCR calendar risk profile graph feb 2014

The graph shows that the stock can fall by as much as $5 and I will make a gain, or it can go up by more than $10 and I should expect a gain.  This seems to be a pretty large break-even range to me.  If I am lucky enough to see the stock end up near my $85 target, it is possible to triple my money in six weeks.

One nice thing about calendar spreads is that you can’t lose all of your investment.   No matter where the stock goes, the value of the April options will always be greater than the price of the March options at the same strike price.  When you are only risking $85 per spread, you can be quite wrong about where the stock ends up and still expect to make a gain.

 

A Post-Earnings Play on Starbucks

Monday, January 27th, 2014

I am a coffee lover, and not only am I adding to my Green Mountain Coffee Roasters (GMRC) spreads discussed last week, I am adding two new spreads this week in Starbucks (SBUX).  By betting on both these coffee companies, I end up not caring whether everyone is drinking coffee at home or at their favorite Starbucks café, just as long as they continue to enjoy the java.And as I sip away at my 4+ cup daily coffee allotment, I can feel I am helping my investments just a tiny little bit.  I will feel so righteous.  The coffee can only taste better.

Terry

A Post-Earnings Play on Starbucks

SBUX announced earnings last week, and they were pretty much in line with expectations.  The stock moved a little higher and then fell back a bit along with everything else on Friday.

The company is doing quite well.  Total sales rose almost 12%, same-store sales rose 5%, earnings were up 25%, and they were opening new stores at the rate of nearly 5 per day (417 for the quarter).

While all those numbers are impressive, the market seems a little concerned over the valuation.  It is selling at 28 times earnings (23 times forward earnings).  The stock has fallen nearly 10% from its high reached just after the last earnings announcement.

The stock has displayed a pattern of being fairly flat between announcement dates.  With that in mind, it might be a good idea to buy some calendar spreads, some at a strike price just above its current stock price ($74.39) and some at a lower strike.

I will be buying SBUX 10 Apr-14 – Mar-14 75 call calendar spreads (natural price $.60, or $625 including commissions) and 5 Apr-14 – Mar-14 72.5 put calendar spreads (natural price $.53, or $278 including commissions) for a total investment of $903.

Here is what the risk profile graph looks like for when the March options expire on the 21st:

SBUX risk profile graph

SBUX risk profile graph

If the stock stays flat, these spreads could just about double the investment in the 52 days I will have to wait.  My break-even range extends about $3 in either direction.  Any change less than $3 in either direction should result in a profit.

Since the stock has fallen so far from its high even though it seems to be doing very well, I don’t expect that any further weakness will be substantial.  On the other hand, the valuation continues to be relatively high so I don’t see it moving dramatically higher either.  It looks to me like a quiet period is the most likely scenario, and that is the ideal thing for a strategy of calendar spreads.

I will report back on the success of these spreads after the March expiration.  I like my chances here.

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