Yum! Brands (NYSE:YUM) is looking to shed two of its less-iconic brands (Long John Silver’s and A&W) but a long-term investor seems to be adding to his or her own bearish position by scooping up LEAP ratio put spreads. The January 2013 40 and 45 puts were active on Monday and it was the second time since late January we have noticed unusually large volume at these strikes.
As the stock was moving modestly higher on Monday to an eventual close of $50.30, an investor apparently sold 3,600 of the January 2013 40 puts, as they traded on the bid price of $3.00 apiece. At the same time, a block of 2,000 of the January 45 puts traded on the ask price of $5.00 each, suggesting they were initiated on the buy side. This spread likely traded with stock, but probably only to aid in its execution.
What is especially interesting about this trade is not even the long-term nature of the play or the 1.8 ratio at which it traded, but the fact that the same strikes saw similar action on January 27. On this day, it looks as though 8,000 of the 40 puts sold for $3.70 each while 5,000 of the 45 puts were bought for $5.90 each. If it is the same investor, they may just be adding to this position with a similar trade fewer than three weeks later.
Let’s look at a profit/loss chart from the OptionsHouse virtual trading platform in order to illustrate how the potential gains/losses for this ratio put spread would look at expiration. Let’s just chart Monday's trade – the 3,600-by-2,000 trade.
A ratio put spread typically looks for the underlying to fall by a predetermined amount and then stop the decline. In this scenario, gains peak at $1.08 million if YUM is trading right at the 40 strike when the options expire. At this level, the short 40 puts expire worthless and the 45 long puts are worth $5 in intrinsic value, so $1 million in total,plus the initial $80,000 credit.
Above the 45 strike, the position gains $80,000. This is the net credit collected after selling 3,600 puts for $3.00 (total credit of $1,080,000) and buying 2,000 puts for $5.00 (total debit of $1,000,000).
On the downside, the breakeven is $33.25. Ratio spreads are difficult to calculate the breakevens when not even ratios such as 2:1 or 3:1, this is another reason the OH P&L calculator is so valuable. It does the complex math for you! Below this point, losses begin to accrue down to zero, because of the 1,600 uncovered short puts.
So this strategy will be at least somewhat profitable (at expiration) if YUM stays put, rises, or falls as much as 33% from its current level to the $33.25 mark. The trade crossed a large bid ask spread, which to me indicates he intends to hold this position for some time allowing the larger number of short 40 puts time to decay. The risk profile will also change as time passes and the share price moves from its current level. Again, the P&L calculator can show the theoretical changes to this position.
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