With Alcoa Inc. (
AA
) kicking off the start of the 2010 second-quarter earnings season
last night, options traders will most certainly become increasingly
obsessed with placing bets ahead of quarterly reports. While Cisco
Systems Inc. (
CSCO
) isn't expected to release its earnings figures for several weeks,
it isn't too early for options traders to begin positioning
themselves ahead of the event. As such, some of today's more than
23,000 call contracts changing hands on CSCO may have been
earnings-related. That said, the most active contract on the
session, the July 22 call, will have expired long before Cisco
steps into the earnings confessional.
Getting to the heart of the options play, the trader sold (to
open) a block of 650 October 27 calls for the bid price of $0.15 on
the International Securities Exchange (
ISE
) at about 1:41 p.m. Eastern time. At the same time, he purchased a
block of 650 October 25 calls for the ask price of $0.53. Given
this data, it would appear that we are looking at a vertical call
spread, more commonly known as a
debit spread
, on Cisco Systems. This options strategy is also known as a long
call spread, or a bull call spread.
The Anatomy of an Cisco Systems Vertical Call
Spread
Breaking down this debit spread position, the trader purchased
650 October 25 calls for the ask price of $0.53, resulting in a
debit of $34,450 -- (0.53 * 100) * 650 = $34,450. In the absence of
the premium received by selling the October 27 call, the trader
would need CSCO to rally nearly 11.7% from Monday's close at
$22.86, to $25.53 per share, in order for the position to reach
breakeven at expiration. Furthermore, the maximum loss on this leg
of the position is limited to the initial investment of
$34,450.
As you can see, the second leg of the debit spread helps to
offset the cost of the overall position. In this case, the trader
sold 650 October 27 calls for the bid price of $0.15, netting a
total credit of $9,750 -- (0.15 * 100) * 650 = $9,750. Combining
this leg of the trade with the purchased October 25 call lowers the
total cost of the entire position to $24,700 -- $34,450 - $9,750 =
$24,700.
The maximum profit is calculated by subtracting the premium paid
from the difference between the two strikes, and is reached if CSCO
rallies to $27 per share at expiration. In this case, the maximum
profit is $1.32 -- (27 - 25) - 0.68 = $1.32 -- or $132 per
contract. The maximum loss is equal to the net debit of $0.68, or
$68 per contract. Below is a chart for a rough visual
representation of the trade's profit/loss scenario:
Implied Volatility
After the vertical call spread has been entered, increasing
implied volatility is pretty much neutral to the overall position,
as it lifts the value of both the sold option and the purchased
option. At the time of the trade, implieds for the October 25 call
arrived at 25.80%, while the implied volatility for the October 27
call came in at 24.18%. For a point of reference, CSCO's
three-month historical volatility was 67.01% as of the close of
trading on Monday.
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