Options Trade of the Day: A Cisco Systems Vertical Call Spread Ahead of Earnings

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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.

CSCO October 25 and 27 call volume details

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.

CSCO vertical call spread details

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:

CSCO vertical call spread profit/loss chart

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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This article appears in: Investing , Options

Referenced Stocks: AA , CSCO , ISE

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