Stock Options Cafe

I just added another spread trade to my mix. I was looking for a stock that was off its highs, had a decent market cap and a dividend. Cardinal Health came up.

You can see it spent the better part of 2017 above $65. It also sports a market cap of over $15B. Let’s get to the option play.

I was able to set up a spread that cost under $1.50 and had a potential return of $10. It would take 30% upside to get into the money, and 50% for maximum profit. Just under a 7X return if this stock goes up 50% in 18 months. I’ll be the first to call this gambling. As I’ve said, it doesn’t take too many wins to make up for a string of losses. Will Cardinal Health return to its recent highs? I don’t know, but for this kind of return, I’ll take a chance.

I was looking for stocks that looked like they were ready to break out, and Facebook came to my attention. Trading at about $165, I wanted to see what return I could get in the options if FB rose by 30% or so by 2019. Here’s what I found.

The spread from $200 to $210 could be bought for $2. In other words, a 27% move up over the next 10 months and my $2,000 would return $10,000. Both strikes were priced pretty high, but that was to my benefit, as I was buying the $200 strike and selling the $210. My net cost was $2/share for a $10 spread. At some point, I might start to increase my purchase size, but in general, I’ve been comfortable to stay with 10 contracts at a cost ranging from $1K-$3.5K. I’m also looking for returns that are over 3 to 1, as I can’t expect every trade to go my way. So far, I’ve had a good run.

DVMT is the tracking stock Dell issued for a portion of its ownership in VMware. It was trading far below the value (compared to VMW) that investors expected. I was able to set up a call spread, based on DVMT trading at $68.50, to buy the July $80 strike, selling the $90 strike, for a net $2. In other words, I need a 31% pop in this stock to return 5X my bet.

Two things to note. The bid/ask suggests a fill at $2.50 for a market order. Which is why I entered this as a limit. Also, only 5 months to run. The very low end of how I like to set up these trades.

I had two great trades close on Friday.

In May, 2016, Apple traded at $99, and I was convinced it would stage a comeback. I bet $1000 that it would close over $150, and now, over 18 months later, it closed at $178.46, high enough that my spread resulted in a $10,000 return for the $1000 risked.

Another trade also closed, LULU (Lululemon Athletica). Here, in April, 2017, with LULU trading at $49.74, I bet $3600 that it would close over $60 by Friday. Sure enough, it closed at $79.34. And the $3600 returned $10,000.

The LULU trade was riskier, in that it had a much shorter time to run, and a smaller return, less than 3X vs the 10X for Apple. On the other hand, only a 20% price move was enough for a successful trade.

I was searching for interesting option opportunities, and happened across some unusual activity on Norfolk Southern. With the stock trading just under $120,  the January 2019 options had this activity.

Someone was betting big, about $15M, that this stock was going to rise as much as 50% over the next 21 months. And when I looked at the profit/loss chart, I saw this. Keep in mind, this is an option spread. I buy one strike and sell a higher one, in this case, dropping my price from $5.03 to $3.50. This makes it more affordable, lowers the break-even, and lets me spread more bets.

The potential for a return of $30,000 on a bet of $3500. The market was offering over an 8 to 1 return if this stock moved 50% over the next just under two years. And a guy with deep pockets was willing to take that bet. My pockets aren’t quite as deep, but this is the kind of return I like to see. I don’t need to have too many winners to come out ahead in the long term. So I put my money where my mouth is.

And, now, we wait. 21 months.

The last time I commented on Gold was 4 years ago. On April 16, 2013 I wrote Gold Recovery? Don’t Bet on it. In that article, I claimed that gold would not rise much by Jan 2015, and sure enough, GLD fell from $132 to $123, no move up. Before that, in fact, before I started here,  in 2009, I wrote Will Gold Break $1250 by 2011? The result was “yes”, it did, and the option play I described was up by a factor of 4. A $2500 bet returned $10,000.

Now, we are, as they say, in interesting times. Jesse Felder of TradingView.com suggests that we are due for a breakout. (Click on the image for the better view)

Now, GLD, the gold ETF, is trading at $122.60, and we are looking at the January ’18 options at different strikes. Let me describe the logistics of the call spread. We can buy the $120 strike and sell the $130 strike. This would cost a net $4.45. And if GLD rose to $130, we’d see a return of $10 for the $4.45 bet. 2.25X our money (A 125% profit) for a 6% move in GLD. This is the amazing thing about trading options, in my opinion.

If we bought the spread from $130 to $140, the cost would be $2.18, and we’d look for a 14% move up to give us a 358% return (i.e 4.58X our bet).

The $140/$150 spread would cost $1.06 and result in an 843% (9.4X) return on a 22% move.

I don’t know what move Jesse is expecting, but at $160, the $150/$160 spread offers an amazing 18X return on a 30% move in GLD.

Let me stop here. Keep in mind, I am not a fan of gold for long term investing, but history showed that when gold breaks out, the potential move of 22% isn’t out of the question. In fact, this 1 year move occurred 3 years of 4, in 2007, 2009, and 2010. The careful use of options would have resulted in spectacular returns.

Lululemon Athletica has been an interesting stock to follow. It tends to tank on bad news, yet always seems to recover nicely. This becomes an opportunity to trade a call spread. From a high of $80 just 8 months ago, it’s dropped to $55, risen past $65, then below $50 on bad new guidance. On April 3, 2017, this was the trade I was considering.

The price of the shares was $49.75. The Jan $50 calls were $6.35, the Jan $60 calls, $2.75. The call spread profit potential is illustrated above. At expiration, I need Lulu to be at or above, $53.60 to breakeven, and I have a maximum gain of $6400 if it trades at $60 or above. The potential is not quite a triple, it’s 2.78X times the money bet. Below is the fill that I got.

Note: The P/L snapshot was taken seconds after my trade filled, so it would reflect my numbers. You can see the tremendous leverage this option spread offers. It returns -100% for a flat stock price, but as much as +178% for a 20% move from the current price. You can also see that if Lulu were to get back to its recent high of $80, the value of this spread would get well above $9000, and I’d probably close it out early. Look at the Lulu chart, and recent news, and tell me if you don’t agree this trade may have been a good one. Last, I wrote A LULU of a deal nearly 3 years ago, a similar trade, call spread, only I was hoping the move would be twice as far, it would need a 50% move for me to make a 500% return. The stock didn’t hit $60, it closed at expiration at $55.71, and my $1700 ‘bet’ returned $5650. Not bad for a failed trade.

Today, Apple is trading at $99. Coming back from prices not seen for 2 years. Here’s the chart I’m looking at.

With the pullback we saw, this is a good time to look at a call spread. Specifically, this one –

I am looking to go out 20 months to January 2018. And I found that the spread from $140 to $150 can be had for $1 net. Let’s recap how this math works and how to enter this trade. The $140 strike is bought for $2.52 and the $150 strike sold for $1.52. This results in a 10X return for a 50% move in Apple over the next 20 months. What if we just bought the $140 strike? The 10X return is still possible, but it would require Apple to hit $165. Only an extra 15%, so possible, and if Apple rose well beyond that, I’d be a bit sad at the gains I passed up, but I’ve had success keep my risk/reward in the range of this trade.

There are a few warnings here. I don’t claim this is ‘investing.’ It’s a gamble, but one where I believe the odds are actually in my favor. To be clear, this is a bet that a stock will rise 50%, and the market is saying, “We think you are wrong and will give you 10 to 1 odds this won’t happen.” I think the odds are far better, perhaps a 1 in 3 chance, 4 tops, certainly not 10. Long term, I’m happy to lose 3 out of 4 times on these, given the high return.

Keep in mind, if the market, and Apple with it, average 10%/yr, or 20% over 2 years, it would take brief bursts of higher returns to average out the down years. Apple can return 10% over a 20 year period , and still provide these high return opportunities every few years.

It’s 2 years since I wrote Betting on Apple at 9 to 2. My bet was that Apple would recover past $600, and in fact, $742 was the close at the options’ expiration. Looking at the trade I made, it couldn’t have gone much better.

Let’s look and see if I might have chosen a better payoff. In this case, $2200 turned into $10000. Had I just bought the calls, the $500 strike for $46.50, the strike would have closed at a value of $242, a gain of 420% vs the 354% gain I saw. The position I entered needed a 35% rise in Apple to get this gain vs 66% gain required to get that 420% return on just buying the $500 strike.

In hindsight, this is one of those rare trades where the only thing I might have done differently was to place a larger position. Most other option trading I do does not yield these results. To be really clear, I am in my 50s and this will go down as one of my top ten option trades, both from a risk/reward standpoint as well as absolute dollars returned.