Options Action –
The show started out with a discussion of how ugly the action was in the market on Friday. The market was mostly under pressure due to European debt concerns more than worry about the US economy. The sentiment on the show was pretty bearish with the feeling that long profits should be taken on any market rallies.
Sticking with the bearish outlook, the first trade recommendation was a bearish spread on the Dow Jones Industrial ETF (DIA). The trade involves buying a Oct 105 Put for 3.50 and selling an Oct 100 Put @ 1.50. This trade costs 2.00 with a maximum potential profit of 3.00. The DIA closed at 109.42 on Friday. The maximum profit from this trade occurs if the DIA closes at 100.00 or lower at October expiration. That’s about a 10% drop in the market over the next six weeks. A drop like that is definitely a bearish call.
The next recommendation is on software company Oracle (ORCL) on the bullish side. The trade is a call spread risk reversal going out to December expiration. This involves selling a December 22 Put for 1.05, buying a December 27 Call for 1.85, and finally selling a December 30 Call for 0.80. As a credit of 1.85 is taken in for selling the two options and 1.85 is paid out for the one long option, this trade would be initiated at no cost. The stock closed at 26.00 on Friday. This trade structure results in buying shares at 22.00 if the stock is under that price at expiration or profiting above 26.00 up to 30.00.
The Striking Price column discussed one of my favorite topics, pairs trading. A pair trade with stocks involves a combination of a long position in one stock and a short position in another. The stocks are usually related through similar business trends or represent leaders in a certain industry. A good example would be combining shares in Pepsi and Coke, taking a long position in one and a short position in the other with an expectation that one will outperform the other.
According to this weekend’s column, derivatives specialists at Morgan Stanley suggested some pair trades with a ‘twist’. They recommend long positions in stocks with business exposure to the US and shorting similar companies that are in similar businesses, but have more exposure to European economies. The twist is they suggest buying call options on the long side of the trade and selling call options on the stocks that are short candidates. This suggestion also results from implied volatility for call options on stocks with European exposure being much higher than the implied volatility for call options on those stocks with more exposure to the United States.
Here’s a list of the potential pair trades (short first, long second) –
Retail – Polo Ralph Lauren (RL) Kohl’s (KSS)
Industrials – Caterpillar (CAT) Union Pacific (UNP)
Insurance – XL Group (XL) Travelers (TRV)\
Software – Citrix Systems (CTXS) Intuit (INTU)
Health Care – Agilent Technologies (A) McKesson (MCK)
As a note of caution regarding this idea, individuals need special approval to have a naked short call position. Also, even though the paired companies are in the same industry there is no guarantee that their performance will mirror each other.