Farming equipment issue Deere & Company (
DE
) has been a favorite in the options pits today, with one
speculator using calls and puts to simulate a long stock position
on the equity.
Earlier today, the investor bought 2,000 December 80 calls for
the ask price of $1.55 per contract, and simultaneously sold an
equal amount of December 62.50 puts for the bid price of $1.43 per
contract. In other words, the trader constructed a
split-strike version of the synthetic long stock
strategy
for an initial debit of $0.12 per pair of options.
By buying out-of-the-money calls and selling out-of-the-money
puts, the strategist is hoping to simulate the payoff of a long
stock position - but at a fraction of the cost. In this particular
situation, the trader - like a stockholder - is betting the shares
of DE will rally in the intermediate term, as his profit will
increase with each step the stock takes north of the $80.12 level
(call strike plus net debit).
However, the options player stands to forfeit a lot less cash in
the wake of a slight pullback on the charts. More specifically,
even if the shares of DE tumble to the $63 level before
December-dated options expire, the speculator's risk is limited to
the $0.12 paid to establish the play. Beyond the $62.50 level,
though, the investor's losses will accrue in parity with DE's
decline, as the sold 62.50-strike puts would move into the
money.
To emphasize the leverage provided by options, let's compare the
risk/reward profile of the aforementioned strategy to that of
buying the shares of DE outright. Since each option represents 100
shares of the equity, we know the options trader spent $12 ($0.12 x
100 shares) to establish the synthetic position. On the other hand,
a straightlaced stock trader would've spent roughly $7,300 to own
100 shares of DE, assuming he bought the stock just before
Tuesday's closing bell.
Now, let's fast-forward a couple of months...
First, let's assume the shares of DE plummet to the $60 level.
In this instance, the long 80-strike call would expire worthless,
while it would cost the options trader $250 (intrinsic value of
$2.50 x 100 shares) to buy back the 62.50-strike put. Adding the
initial net debit of $12, the options player's loss would amount to
$262 per pair of contracts. On the other hand, the stock trader's
100 shares of DE would be worth just $6,000 - a loss of $1,300 from
his initial investment.
Moving on, let's say the shares of DE retreat to the $70 level
before December-dated options expire. In this scenario, both
options will expire worthless - meaning the strategist will be out
the $12 paid to establish the trade. Meanwhile, the stockholder's
stake would be worth just $7,000 - a $300 deficit.
Now, what happens if the shares of DE rally to the $85 level by
expiration? In this best-case scenario, the sold put would expire
worthless, while the bought 80-strike call would have an intrinsic
value of $5, or $500 (x 100 shares). Subtracting the initial debit
of $12, the options trader would net a profit of $488 - a return of
more than 4,000%. In comparison, the stock owner's shares would be
worth a combined $8,000 - a profit of $700, or less than 10% of his
initial investment.
In conclusion, by employing the right options strategy, bullish
bettors can simulate the payoff of stock ownership without having
to fork over a ton of cash. Plus, since the aforementioned
strategist sold puts and bought calls at different strikes, his
risk is limited should the equity remain between the strikes
through expiration. In fact, some synthetic long stock positions
are even initiated for a net
credit
- meaning the investor can net a small profit even amid stagnant
price action.
Click here for the new summer issue of
SENTIMENT magazine