Option Investor

Daily Newsletter, Monday, 07/11/2005

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Options 101

Market Wrap

The Market That Could

The Market That Could

Equity bulls maintained Friday's rise, reaching new highs for the move and closing at the session highs after a corrective intraday dip. Despite extremely overbought intraday cycles and extremely low put-to-call readings in the morning, the markets moved higher and maintained a persistent underlying bid throughout the session.

Volume breadth was strong throughout the session, never even approaching neutral on the intraday dip and finishing at 3.36:1 for NYSE advancing volume and 4.97:1 on the Nasdaq. Volume was respectable, with a combined 3.16B shares traded on the NYSE and Nasdaq, and QQQQ volume 96.5M shares for the day.

Daily Dow Chart

The Dow finished 15 points off its 10534 high, rising from its opening low at 10449. 10440-450 had resistance since late June, and today's tall bullish candle built on the strong gains from the London bombing's doji low below 10160. This setup has been sufficient to turn the daily cycle indicators sharply higher, reversing the bulk of June's gains in a mere 3 sessions. There was more strength after the cash close, casting doubt on the intraday downphases discussed in the Market Monitor. While today's high remains below the June and March highs, the strong volume on the launch off last Thursday's doji bottom and the uncompromising move higher from there is causing bears to second-guess their assumptions, if the decline in volatility and the low put to call readings this morning were any indication.

Daily S&P 500 Chart

The picture is more bullish on the SPX, as the June highs were exceeded at today's 1220.03 high. The SPX closed at 1219.44, a bullish finish to conclude the afternoon's corrective dip. The return to the earlier intraday high after bouncing from a higher low suggests further strength tomorrow on a possible intraday rising triangle break above 1220. The March high at 1127-1230 will be next confluence resistance if the bulls can do it.
While the weekly cycle upphase is nearing the top of its range, suggesting that upside could be limited from here, there's still plenty of room in the daily cycle upphase for a run lasting 1-2 weeks should bears fail to regain the 1212 and 1206 levels.

Daily Nasdaq Chart

The Nasdaq also cleared major resistance today, in this case the 6 month old horizontal resistance at 2100-2110, with the Nasdaq closing 22.55 at 2135.43. QQQQ finished at its session high. I've read a great deal of speculation as to whether the 2100-2110 line was a reverse head and shoulders neckline, in which case the implied target would be as much as 200 points higher.

I'm not persuaded by that interpretation, not because of the potentially high target, but because on a cycle basis, reverse head and shoulder formations are only valid at the bottom of a longer cycle decline. J.M. Hurst discusses the pattern as resulting from the interplay of shorter cycles trending within longer ones- in this case, a reverse head and shoulders would result from a daily cycle upturn taking shape within a weekly cycle bottom. In this case, however, the weekly cycle indicators are just entering overbought, and if anything, a failure below 2160 would set up a broad and sloppy head and shoulders (not reverse) above 1750ish. In any event, the price will tell us. Next resistance is at 2140-45 at the former bear wedge apex, while bears need a break below 2100-2110, confirmed by a move below 2075 to stall the daily cycle upphase.

Daily TNX Chart

The Treasury auctioned $17 billion in 13-week bills and $15 billion in 26-week bills today. Foreign central banks were awarded $8.7 billion of the total. The 13-week bills received 2.53 bids for each awarded, the highest bid-to-cover ratio since the April 25th auction. However, the high-rate was 3.204%, the highest since 2001. The 26-week bills generated a bid-to-cover ratio of 2.34, the highest June 6th, and another 4-year high high-rate of 3.4%.

Despite another net add from the Fed's open market desk, ten year note yields (TNX) were buoyant again, breaking 4.14% resistance for the first time in a month and spending the day in positive territory until the final minutes of the cash session. The mostly steady march higher for the TNX has been puzzling since the Fed's massive net $14.5 billion repo add one week ago. With these repos being fed to the Fed's primary dealers at stop out rates below the 3.25% target rate, the lack of demand for treasury bonds has been strange. In any event, the daily cycle upphase for the TNX continues, with TNX now testing the key 4.14%-4.16% confluence zone that has held back the yield since breaking below it in May. For the day, TNX closed -0.7 bps at 4.102% on an end-of-session dip.

Daily Chart of Crude oil

Crude oil futures held below 60 today as Hurricane Dennis was downgraded to "tropical storm" status and a number of oil producers announced that their facilities would be coming back online today. Risk Management Solutions estimated the value of insured losses caused by the storm between $1 billion and $5 billion. Last year, Hurricane Ivan caused more than $7 billion of insured losses. The US Minerals Management Service reported that Dennis caused 445 rigs and platforms to be evacuated, halting over 96% of daily oil and 62.4% of daily natural gas production in the Gulf of Mexico.

On the daily chart of front-month August crude oil, we see that today's unfilled gap down was sufficient to print sell signals in the daily cycle indicators. Those sell signals printed from bearish divergences at the highs, signaling a potential strong downphase from here. Bulls need to hold the rising support line at 58, while bears will be gunning for a break to confirm the overdue daily cycle downphase. August crude oil finished lower by .75 at 58.875, off a session low of 58.05. Meanwhile, Marketwatch reported that the average retail price of regular unleaded gasoline printed a new record high of $2.291 per gallon, breaking the April 11 record of $2.276.

It was a quiet day for economic data, with the first economic reports of the week scheduled for Wednesday with Export and Import Prices as well as the Trade Balance. Later that day we'll get the Treasury Budget for June, followed by Retail Sales, the CPI and Initial Claims on Thursday. On Friday, it's the Empire State Index, Business Inventories, the PPI, Industrial Production and Capacity Utilization, and Michigan Sentiment.

In corporate news, pharmaceutical, medical-surgical and information solution provider McKesson (MCK) announced its intention to buy D&K Healthcare Resources (DKHR) at a 71% cash premium to DKHR's closing price of $8.50 on Friday, as well as an assumption of DKHR's outstanding debt. MCK expects the acquisition to close during Q3 2005, and to be accretive to earnings by 2007. MCK gained 1.48% to close at 45.21, while DKHR rocketed up 68.24% to close at 14.30.

Overnight, LG Philips (LPL) announced Q2 earnings which fell from $678 million from this quarter last year to $40 million in the first quarter. This precipitous decline was tempered by the fact that Q1 saw a net loss of $76 million. Sales were up from Q1 as well, rising 12% to $2.23 billion, which was nevertheless lower by 1% from Q2 2004. The company attributed the jump from Q1 to more accessible pricing in LCD TVs, and expects more of the same as lower prices attract demand in the second half of this year. LPL gained 4.94% to close at 22.75.

DreamWorks Animation (DWA) warned today that it sees a Q2 loss of $.07 to $.09 per share, down from its previous guidance of breakeven. For the full year, DWA expects to see EPS of $.80-$.90, down from earlier projections of $1.00-$1.25. DWA also announced that it will withdraw its $500 million common stock offering. The company cited an increase in return reserves for its 2004 titles for the profit warning and valuation concerns for the decision to cancel the stock issuance. Later in the session, the company disclosed that it has received an information request from the SEC regarding its May 10th financial report and trading in DWA securities. The request for information was characterized by the SEC as "informal." DWA got whacked for a 13.20 loss to close at 23.27.

Also warning was semiconductor equipment maker Brooks Automation (BRKS), which sees fiscal Q3 revenue coming in between $111-$113 million, down from its previous $115-$120 million target. The company cited delays in some customer projects. BRKS lost 1.8% to close at 15.31.

Industrial chemical maker Celanese (CE) announced that Q2 earnings would be strong, based on "strong fundamentals," with EPS projected at $.39-$.44. The previous outlook was for a range between $.36-$.41 per share. CE's full-year is expected at $1.64-$1.69 per share. CE added 4.37% to close at 16.94.

Sprint (FON) announced its intention acquire its wireless affiliate US Unwired (UNWR) for $1.3 billion, pursuant to which FON will pay $6.25 for each UNWR share and assume $266 million of UNWR debt. The acquisition will also terminate a lawsuit that UNWR had brought against FON. FON rose .07 to close at 25.45, while UNWR gained 4 cents to close at 6.20.

After the bell, Genentech (DNA) announced Q2 results of 27 cents or $296.2 million, up from $170.8 million or 16 cents in the year-ago period on revenue that rose from $1.13 billion to $1.53 billion in the current quarter. Net of litigation and other charges, EPS was 30 cents, beating consensus estimates by 4 cents. DNA rose 25 cents to 83.75 afterhours, building on today's .40% gain to 83.50.

In other news, Marketwatch reported that Reserve Funds, which manages more than $25 billion and launched the world's first money-market fund, reported that client cash in sweep accounts is up more than 30% this year to $1.3 billion. This is potentially compelling anecdotal evidence of a buildup of cash "on the sidelines," and while $1.3 billion is certainly real money, it's difficult to get excited about it from a macro perspective in light of the huge amounts that the Fed's open market desk routinely throws around ($2.25 billion of net new money was added today alone via a $7 billion overnight repo, and last Tuesday, it was a $14.5 billion net add).

For tomorrow, the market will again reflect on the price of oil and treasury yields as we await Wednesday's economic data, the first of the week. Equity bulls will be seeking to defend today's range against the intraday corrective pullback that failed to gain traction today. A break of the lows would suggest potentially more than just corrective weakness, but with the futures firm afterhours as of this writing, the bears should have their work cut out for them. A break of today's highs could send them running for cover, extending the trending move off Thursday's lows further still.

While traders might not believe the firm, nearly pullback-free move, that disbelief has so far acted as a wall of worry to be climbed. Today's opening sub-.50 total put to call ratio looked like a brick wall for the bulls, but they disregarded it easily. In such cases, as always, price is the primary indicator- don't let yourself stare in disbelief as the price runs away. Similarly, if you're holding bullish profits, don't let a break of today's lows go unnoticed, as it could spell trouble for the daily cycle upphase that has brought us the gains from last week's low. In either direction, let the stops do their work.


New Plays

New Option Plays

Call Options Plays
Put Options Plays
LOW None

New Calls

Lowes Corp. - LOW - close: 60.73 chg: 1.21 stop: 56.90

Company Description:
Lowe's is a proud supporter of the American Red Cross, Habitat for Humanity International, United Way of America, and the Home Safety Council, in addition to numerous non-profit organizations and programs that help communities across the country. Lowe's Charitable and Educational Foundation awards more than $3 million annually to diverse organizations across the United States. Lowe's also encourages volunteerism through its Lowe's Heroes program. Lowe's, a FORTUNE 50 company with fiscal year 2004 sales of $36.5 billion, serves more than 11 million customers a week at more than 1,100 stores in 48 states. (source: company press release or website)

Why We Like It:
Hurricane season always means big business for the home improvement chains like LOW and HD. While hurricane Dennis, that hit landfall this past weekend, may have been more bark than bite, the forecast is for a pretty heavy storm season this year. Maybe that's why shares of LOW have powered through resistance at the $60.00 level to hit new all-time highs today. A positive market environment doesn't hurt. Today's move helped confirm the MACD buy signal and we see that volume was almost double the norm, which suggests more strength ahead. Today's breakout also produced a new triple-top breakout buy signal on its P&F chart that now points to a $79 target. We will admit that with the major averages up strong three days in a row that odds of a market pull back are growing. Traders may want to wait before initiating bullish call positions in LOW. A dip to the $60.00 level would be an attractive entry point or a bounce from the $59 level would also work well. However, we are willing to buy calls right here. Our target is the $64.50-65.00 range before LOW reports earnings in mid-August.

Suggested Options:
We are suggesting the August calls although Octobers are also available.

BUY CALL AUG 55.00 LOW-HK OI= 266 current ask $6.20
BUY CALL AUG 60.00 LOW-HL OI=1639 current ask $2.20
BUY CALL AUG 65.00 LOW-HM OI=2019 current ask $0.40

Picked on July 11 at $ 60.73
Change since picked: 0.00
Earnings Date 08/15/05 (unconfirmed)
Average Daily Volume = 3.4 million


Pediatrix Med Group - PDX - cls: 76.10 chg: 1.47 stop: 72.34

Company Description:
Pediatrix was founded in 1979. Pediatrix physicians and advanced nurse practitioners are reshaping the delivery of maternal-fetal and newborn care, identifying best demonstrated processes and participating in clinical research to enhance patient outcomes and provide high-quality, cost-effective care. Its neonatal physicians provide services at more than 220 NICUs, and through Obstetrix, its perinatal physicians provide services in many markets where Pediatrix's neonatal physicians practice. Combined, Pediatrix and its affiliated professional corporations employ more than 790 physicians in 32 states and Puerto Rico. Pediatrix is also the nation's largest provider of newborn hearing screens and newborn metabolic screening. (source: company press release or website)

Why We Like It:
We normally don't like to play stocks that don't have an average volume of at least 300,000 shares a day or more. However, occasionally we'll make exceptions. PDX is one of those exceptions. The stock broke through major, multi-year resistance in the $70.00-72.50 region back in early May of this year. Since then the stock has been churning sideways in a trading range of $72.35-75.50 maybe $76.00. Today's market rally and news of PDX new expansion in the Tampa-St. Petersburg, Florida area helped push the stock to a new all-time high and a breakout through the top of its trading range. The move also produced a new triple-top breakout buy signal on its P&F chart, which now points to a $92.00 price target. We want to buy calls here and target a move into the $80.00-82.00 range. We do plan to exit before the company's early August earnings report. You may want to wait for confirmation that PDX is bouncing from the $76 level before initiating positions. If the markets dip tomorrow then we'd watch for support near the $75 level.

Suggested Options:
We are suggesting the August calls since we plan to be out before its August earnings report.

BUY CALL AUG 70.00 PDX-HN OI= 49 current ask $7.20
BUY CALL AUG 75.00 PDX-HO OI=174 current ask $3.40
BUY CALL AUG 80.00 PDX-HP OI=104 current ask $1.20

Picked on July 11 at $ 76.10
Change since picked: 0.00
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 158 thousand

New Puts

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Chubb Corp - CB - close: 86.72 change: 0.77 stop: 83.99 *new*

Another positive day in the markets helped push shares of CB toward resistance at the $87.00 level. The stock looks poised to breakout to new highs. Our target is the $89.50-90.00 range. We are raising the stop loss to $83.99.

Picked on June 10 at $ 85.05
Change since picked: 1.67
Earnings Date 07/26/05 (confirmed)
Average Daily Volume = 1.2 million


Cummins Inc - CMI - close: 77.03 change: 2.01 stop: 73.49 *new*

It was a big day for CMI. The broad market rally helped push CMI through resistance at the $76.00 level. The stock closed above the $77 mark and is within striking distance of our $77.50-80.00 target range. We're suggesting that traders prepare to exit. We are raising our stop loss to $73.49.

Picked on June 19 at $ 74.03
Change since picked: 3.00
Earnings Date 07/22/05 (confirmed)
Average Daily Volume = 970 thousand


Coventry Hlth Care - CVH - cls: 73.37 chg: -0.57 stop: 69.49

The healthcare sector was one of the only groups to close in the red today. CVH followed its peers lower but we remain bullish on its prospects. A rebound from the $72.00-72.50 region would be an attractive entry point for new calls.

Picked on July 05 at $ 72.75
Change since picked: 0.62
Earnings Date 08/02/05 (unconfirmed)
Average Daily Volume = 1.0 million


Fortune Brands - FO - close: 93.51 chg: 0.28 stop: 88.99

The RLX retail index surged to new six months highs today and this gave shares of FO a lift. The stock came within 50 cents of our $95-96 target range. The good news is that both the RLX and FO look poised to continue higher tomorrow.

Picked on July 03 at $ 90.51
Change since picked: 3.00
Earnings Date 07/22/05 (unconfirmed)
Average Daily Volume = 648 thousand


Intuit - INTU - close: 47.36 chg: -0.70 stop: 43.90

The rally in shares of INTU took a pause today. Shares had become a little over-extended and need a break. We see no changes from our previous update. Our target is the $49.50-50.00 range.

Picked on July 07 at $ 46.51
Change since picked: 0.85
Earnings Date 08/17/05 (unconfirmed)
Average Daily Volume = 1.7 million


Noble Energy - NBL - close: 80.14 chg: 0.74 stop: 75.99 *new*

NBL continues to look strong and today's bounce back over the $80.00 mark could be a new entry point. Our target is the $84-85 range. We're raising the stop loss to $75.99.

Picked on July 05 at $ 78.15
Change since picked: 1.99
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 1.0 million


Quanex - NX - close: 56.82 change: 1.34 stop: 52.99 *new*

Widespread gains across the market today are a fertile ground for NX's growing breaking above the $55.00 level. Our target is the $59.50-60.00 range. We're raising the stop loss to $52.99.

Picked on July 07 at $ 55.10
Change since picked: 1.72
Earnings Date 08/25/05 (unconfirmed)
Average Daily Volume = 337 thousand


Reynolds American - RAI - close: 79.76 chg: 0.93 stop: 76.49

Our new bullish play in RAI is off to a good start with more follow through on its rebound from the bottom of its trading range. We see no changes from our weekend update.

Picked on July 10 at $ 78.83
Change since picked: 0.93
Earnings Date 08/01/05 (unconfirmed)
Average Daily Volume = 664 thousand


Rio Tinto - RTP - close: 128.01 chg: 2.12 stop: 121.49

Good news! RTP has broken through technical resistance at its simple 100-dma with today's 1.68 percent gain. The stock looks poised to make a run toward our target in the $129.50-130.00 range. More conservative traders may want to consider taking some profits right here though.

Picked on June 27 at $123.33
Change since picked: 4.68
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 160 thousand


Toll Brothers - TOL - close: 53.96 chg: 1.98 stop: 48.95

TOL is seeing a very positive post-split reaction. The stock added 3.8 percent today on (obviously) above average volume. The stock began trading on a split adjusting basis following its 2-for-1 split over the weekend. If you missed the entry point this morning you might want to wait for a dip before jumping in. Our target is the $57.50-60.00 range.

Picked on July 10 at $ 51.98
Change since picked: 1.98
Earnings Date 08/22/05 (unconfirmed)
Average Daily Volume = 2.4 million


Sunoco Inc - SUN - close: 120.94 chg: 0.64 stop: 114.99

No change from our previous update. Our target is the $124.50-125.00 range. SUN has a 2-for-1 split on August 1st.

Picked on July 03 at $117.87
Change since picked: 3.07
Earnings Date 07/21/05 (unconfirmed)
Average Daily Volume = 1.3 million


Wellpoint Inc - WLP - close: 71.21 chg: 0.46 stop: 67.49

Healthcare was one of the only sectors trading lower on Monday but WLP bucked the trend. The stock added 0.6 percent to close near all-time highs. The gain may have been attributed to positive news. WLP announced that it has settled two class action lawsuits brought by more than 700,000 doctors over "alleged unfair payment practices" (source: AP). We see no change from our weekend update. Our target is the $74.00-75.00 range.

Picked on June 05 at $ 68.40
Change since picked: 2.81
Earnings Date 07/27/05 (unconfirmed)
Average Daily Volume = 3.5 million

Put Updates


Dropped Calls

Fording Candn Coal - FDG - cls: 98.10 chg: 2.14 stop: 89.49

Target achieved. Today's broad market rally could not outpace the strength in shares of FDG. The stock added another 2.2 percent and traded into our suggested target range of $97.00-100.00. We initially suggested the September strikes and they've all seen significant increases in value. We're closing the play at the $97 mark but more aggressive traders may want to just ratchet up their stop loss and let the stock run or aim for the $100 region, which is likely to act as round-number, psychological resistance.

Picked on June 19 at $ 90.30
Change since picked: 7.80
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 384 thousand

Dropped Puts

Ambac Fincl. - ABK - close: 70.94 chg: 1.89 stop: 71.01

It has been very tough to be a bear the last few days with the broad market indices rebound higher and breaking out through resistance. Today's market gains helped fuel the rebound in shares of ABK, which added 2.7 percent to push through, at least temporarily, the $71.00 level. We have been stopped out at $71.01.

Picked on June 26 at $ 69.62
Change since picked: 1.32
Earnings Date 07/20/05 (unconfirmed)
Average Daily Volume = 992 thousand

Options 101

Combining the Horizontal Debit Spread with the Vertical Spread

Try this strategy when you are looking for a move during a later expiration period and want to reduce your initial capital outlay, try utilizing a horizontal spread initially, and if all things go well, leave yourself the potential of converting your horizontal to a very inexpensive debit spread later on.

The Theory behind the Practice

How many times have we decided to put on a simple debit spread maybe 2-3 months out in time and lock in maximum gain or maximum loss potential. Here is a little twist that you might want to consider before utilizing the further out debit spread that MAY work to your advantage if you believe the following:

1. That your underlying stock indicates a neutral to slightly bullish signal for the next 30-day option cycle. This would be for anyone of numerous reasons. (I.e. earnings, cycle season, etc.)
2. That you are willing to initially pass on your debit spread at the longer expiration in return for being rewarded if your reason #1 is correct.

If that is the case, here is a strategy you might want to employ. Remember, as always, any trade you put on ultimately should be with your INTENT when making the trade.

Hypothetical stock JKL is trading for 40 and has the following option series available

Figure 1:

Initially we could put on the July debit spread, buying the JKL July 40 Calls and selling the JKL July 45 calls for a debit of 1.60 or $160 each and that would be the end of it.
We know the maximum return that we could receive would be $340 (The difference between the strike prices minus the difference in the premiums) and the maximum loss would be $160, which is our difference between the two strike prices. However, let us go back to the INTENT of our trade based on the two (2) premises above. (1) We expect that the stock will be neutral to slightly bullish the next 30 day option cycle and (2) will are willing to give up putting on the debit spread initially if we could be rewarded later for being right about our first belief for the trade.

So instead of putting on the July 40-45 debit spread we put on a horizontal/vertical spread
As follows:

Using the same numbers from Figure #1 above. Instead of selling the JKL July 45 call and receiving a premium of $1.90 or $190, we sell the JKL June 45 Call for $1.00 of $100 each. So probably are thinking, Why are we putting on this spread and receiving less money and a spread that is costing us $400 instead of $310! Well lets return to the INTENT of the trade and remember what our analysis of the underlying JKL stock was. Remember, neutral to slightly bullish for the next expiration period. Now with that in mind here is the intent of the strategy. If our first observation regarding neutral or slightly bearish analysis of the stock is correct then the stock should trade in a range easily between 40 and at the most 45.

NOTE: The closer to 45 that the Jun expiration closes the better for us.
See Figure 2: (below)

FIGURE 2: JKL now selling at 45 (New option series looks as follows)

Here is why:
1. If we are right and the stock closes close to 45, the June 45 options expire worthless and we keep the $1.00 of $100 per option. However, we also now have a long JKL Jul 45 Call that is 5 points in the money that we could sell at this time and need out at least $5.00 per option plus anywhere from $.70 to $1.00 ($70 to $100) in addition for time value left for the 30 days left in the July option cycle.
PROFIT: $100 for the JKL June expired 45 Calls plus at least a $150 Profit for the JKL July 45 Call (trading at 40 the option has $500 of Intrinsic value in it and at least $70 - $100 time value left for the remaining 30 days of the July expiration cycle. That would be $570 - $350 initial premium paid for the JKL July 40 Call or $220 Profit. Now combine that with the $100 for the JKL Jun 45 expired contracts and you have a NET PROFIT of $320. Which would be only $20 less then if we held the position until the July expiration cycle and if the July cycle had the underlying JKL stock closing at 45 or higher. However, this is just one (1) of our options. Once, again if you remember the INTENT it was a neutral to slightly bullish move. So we could now, put on our debit spread by selling the JKL July 45 calls for approximately $2.00 or $200 (based on the assumption that I could get $2.00 for a 30 day call, like I received for Jun, which is a more than fair assumption.). Hence you would end up being Long the JKL July 40 Call and Short the July 45 Call.

CONCLUSION: If the stock closes anywhere above 45 your debit spread closes out with a $500 credit, which is the difference between the intrinsic values of the stock strike prices, because but would in the money with the 40 always worth 5 points or $500 more no matter how high the stock closed. So you would end up if the stock closes as follows

A. If JKL closes over 45 dollars a share your account gets credited $500 for the difference in the strike prices, plus add the $100 you received for the expiration of the Jun 45 calls. Net credit to your account $600. Your risk $400, was reduced by the premium you received for the JKL Jul 45 call, in this case $200. So your actual risk/reward once you sold the JKL July 45 Cal is a $600 maximum gain per contract versus only $200 maximum loss, and the loss would occur if and only if the underlying JKL closes below $40 on the July expiration. This was the original Long July 40 call and the Short Jun 45 call, which was the horizontal spread.

B. The advantaged gained here is that you have a choice of closing out the position earlier than you had planned if the stock is trading near 45 come Jun expiration or checking to see if you could get more potential income or return by selling the JKL July 45 against the Long JKL 40 Calls. Once again, it leaves you with a immediate win situation or potentially a chance to gain more with a debit spread than you might have if you had just put on the Long JKL July 40/45 spread initially.

C. You also have the additional option of shorting the JKL July 50 Call for $1.00 or $100 this would then give you a debit spread of Long JKL July 40 and short JKL July 50. Hence your risk reward would be even better now your net risk is reduced by the Jun 45 call premiums of $100 that expired and an additional $100 reduction from the JKL July 50 call premiums you put on. Now this Debit spread would have a risk of $150 (The two premiums you received for the JKL Jun 45 calls and the JKL July 50 calls equally $100 plus $100 or $200 subtracted from the $350 you paid for the Long JKL July 40 calls. Your TOTAL NET DEBIT is now only $150 and your maximum is now potentially $850. The difference is the strike prices (JKL July 40 and 50 or $1000) minus the difference you received in the premiums (which is $350 - $100 June 45 calls and $100 July 50 calls)
MAXIMUM GAIN ($1000 - $150) - $850
I lot better potential return then the initial debit spread of the Long JKL July 40 calls and the Short July 45 Calls.

The other issue to consider here is if the stock doesnt move much above your initial price of 40. Then you might only be able to receive a premium of $1.00 or $100 for your JKL July 45 calls if you then decide to sell them against your Long JKL July 40 Calls. However, your spread would still cost you $0.10 or $10 less per contract then if you just put on the spread initially. You most also take into consideration, that if the stock did not move, that was still part of your analysis, Neutral to slightly bullish. So you are in no worse of a position then if you just initially put on the Long JKL Debit Spread for July.

The Real World Example: Actual Date May 19, 2005: SPX trading at 1191.31

CHART 1: SPX CHART Standard and Poors 500 Index

Figure 3: SPX Option Chart

(Actual option prices above)

Taking the actual SPX numbers for the June and July Option Series
We could examine an SPX horizontal spread like our hypothetical JKL. The only difference here is that the option premiums are going to be higher because we are going to look at the SPX Index. So if the market is up the index is going to go up, as opposed to the whims of a one particular stock. Once again, we could just put on the SPX debit spread for July, which would be

SHORT SPX JUL 1215(SPT-) for a credit of $10.40 pr $1,040 Credit
LONG SPX JUL 1195 (SPT-GS) for a debit of $18.50 or $1,850 Debit.

Hence the spread would cost you an $810 NET DEBIT. Your risk/reward would be a maximum loss of $810 and a maximum gain of $1,190. With a breakeven at 1202.10 on the SPX. Not a bad risk/reward ratio. But what if we felt neutral or slightly bullish like in our hypothetical example above. We could sell the June 1215 for a credit of $4.50 or $450 instead of the July 1215 Call for the $10.40 or $1,040 credit. Once again, we are taking less of a premium credit because we sell the shorter call strike in June. This horizontal position looks like this:

SHORT SPX JUN 1215(SPT-) for a credit of $ 4.50 pr $450 Credit
LONG SPX JUL 1195 (SPT-GS) for a debit of $18.50 or $1,850 Debit.

NET DEBIT = $1400, which is our maximum loss and only $600 is our maximum gain.

So, you say to yourself, What a lousy risk reward Until you remember your trade INTENTION. Once again if the Index moves anywhere close to 1215 near the June expiration and not above 1215, the 1215 June calls would expire worthless and you would keep the $450 you received for those June 1215 calls, in addition you would be able to either cash out the Long position for at least $2000 (since the 1195 would be 20 points into the money, plus at least 3-4 points ($300 - $400) of time value for the month of Jul that is remaining.

Figure 4: Hypothetical close of Jun expirations with Hypothetical prices for JUL options based on what equivalent 30-day options would be selling for.

Once again you could close out the position early or sell a 1215 Jul call for around $10.00 which is what a one month at the money call would sell for this index with one month to go. (Similar to the Jun 1195 Call which was selling for $10.40 (see figure 2 above). So once again you are left with a choice. You can close out the long position and take $2000 plus $300-$400 of time value in that option as well, giving you a net of $2300 - $2400 for the sale of the Long Jul 1195 plus the $450 you received for the expired SPX Jun 1215. This gives you a total of $2750 - $2850 and you are out of the position early with a profit of $900 - $1000, but you are out of the position one month early then the JUL DEBIT SPREAD had you entered into that spread position.

OR you can sell the SPX Jul 1215 Call against your LONG JUL 1195 position and take in close to $10.00 to $11.00 per contract ($1,000 or $1,100). Now in receiving this extra income you now have your original JUL 1195/1215 Debit Spread but your risk reward is now $2000 it the Index closes above 1215 (the 20 points for the 1195 being into the money, and the $1,000=$1,100 for your sale of the JUL 1215 Calls. This gives you a net credit of $3000 for your $1400 risk. Which compares to the $1,190 gain versus the $810 risk? However, you still have the additional option of increasing your potential profit by selling a further out call (ex. The JUL 1220. 1225, 1230, etc.) Taking in fewer premiums, but giving you more upside potential. The possibilities are endless and the risk are always still inherent anytime you decide to put on the vertical debit spread at a higher strike point for more potential gain. It ultimately comes back to what you are trying to achieve and how much reward you are anticipating.

The Bottom Line:

This strategy basically is used to reduce your net capital outlay, give you the potential to put on a risk free trade, or even given you the option of taking an earlier profit then you had plan by holding the position for a shorter period of time then you had initially intended. Of course, if like any other type of option strategy, your Underlying Stock or Security doesnt perform as you predicted, you will face a lost, but still by using the horizontal spread, if you are initially right, your loss could be significantly lower, while if correct you are left with several potentially profitable scenarios.

Today's Newsletter Notes: Market Wrap by Jonathan Levinson, Options 101 by Steven Gail, and all other plays and content by the Option Investor staff.


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