Trade 3 - 22nd June 2005 (Closed)

Last updated 13th September

Strategy: Call Backspread

Underlying: APCC (American Power Conversion)

Closed Position as at 13th September 2005

Short 1 August $22.50 Call Option @ 2.30 Expired. Exited at 3.26 (-0.96)
Long 2 August $25.00 Call Options @ 0.90 Expired. Exited at 0.76 (-0.28)

Net loss of $124 per option spread (62% ROI).

Background and Trade Setup

Now and then I receive stock alerts from StocksAndOptionsTrading. The author - Travis Mijat, has a developed his own method of defining turning points for stock trading called "Turning Point Boxes". I am on their mailing list and receive a couple of freebie stock picks every now and then.

I recently received an email from Travis with a tip on a stock called American Power Conversion (Ticker: APCC). Travis' recommendation is to buy APCC and has placed a target price of 28.50 with box levels of 22.50 and 25.00. Let's see if we can turn this pick into a winning option strategy.

This is the chart Travis sent through with the email.

Travis is bullish on this stock and expects an explosive move pretty soon. We know that if we are bullish on market direction and volatility, we can go into the options market and simply buy and out-of-the-money call option.

But I'm going to play it a little safer with this trade and go for an each way bet with some more upside potential.

Basically I want to benefit both if the market rallies or market crashes, but I'm also confident in Travis' pick so I want an option strategy that will make more if the market rallies.

If you've browsed through the option strategies in this site you will probably recognise this type of position as a Call Backspread.

A call backspread is an option strategy combination where you sell one in-the-money call option for every two out-of-the-money call options you buy. This combination will make money in either situation: market rallies or market falls at option expiration.

Before we put on this trade, however, we have to decide what strike prices we are going to use for the option spread.

For option prices I use Yahoo!. They are free but delayed by 15 minutes. The strike prices for the August series are 15, 17.50, 20, 22.50, 25, 30, 35 and 40.

After playing around with these strikes in the Option Trading Workbook I settled on 22.50 and 25 strike prices for our combination. I entered these values into the OptionPage tab and entered the strategy into the OptionStrategies tab.

The trade is as follows:

Sell 1 $22.50 Call Option @ 2.30

Buy 2 $25.00 Call Options @ 0.90

Here is the payoff chart of this option strategy applied to APCC.

And here is what our call option series looks like when priced up using the Option Trading Workbook spreadsheet.

Note, the date I used was the 22nd of June. This is because even though Travis' email shows the 17th, I didn't take a look at the email until the 22nd. For this reason I began my analysis on the 22nd June.

Now, as you know, a Call Backspread is usually done at a credit: i.e. the money you receive from selling the in-the-money call option is usually more than the money you have to pay for buying the two out-of-the-money call options.

You can see from the market prices that this is the case with our spread too. We will receive a net premium of $50 for every spread we do before brokerage costs.

Remember that US stock options have a contract size of 100, which means that for every 1 option contract you buy or sell is worth 100 underlying shares. So, if an option contract is showing a price of 1.50, this means that you will have to pay $150 to buy it.

After entering these values into the spreadsheet we can now calculate our risk profile for this option strategy.

In total we will receive $50 up front for putting on this option combination. Our maximum upside profit is unlimited and our maximum downside profit is $50.

Our maximum loss on this trade is $200, which will occur if the market settles at $25 on expiration.

Our break even points for this trade are $23 and $27. If APCC is trading above these levels by expiration we can make money. Here is a chart of APCC with our break even points included. As long as APCC can break away from the horizontal lines before the end of the chart we can win with this option strategy.

Let's take a look at a TradeStation chart of APCC with the Historical Volatility indicator applied.

You can see that short term (30 day) volatility is quite low relative to both medium (50 days) and long term (100 day) volatility.

This is also good for our option strategy: we want an increase in market volatility, which should help our stock break away from current ranges.

Let's see how this strategy goes.

Update - 10th July 2005

So far so good. APCC closed at 23.61 on Friday - just 61 cents away from our lower break even point.

And here are the closing levels of the options from Friday's close:

Here is our option position now as at Friday's closing levels:

Sold 1 $22.50 Call Option @ 2.30 - Now trading at 1.50 (Profit of 0.80)

Bought 2 $25.00 Call Options @ 0.90 - Now trading at 0.60 (Loss of 0.60)

So, our net position is currently showing a profit of 0.20 per contract. Multiplied by the option's contract size of 100 means we have an unrealised profit of $20 per contract so far for a maximum loss of $200 - or a 10% return in 18 days.

There is still 58 days left and I think APCC still has a good chance to break away from our lower break even point. Let's see...

Update - 15th July

Our position is not looking too good right now. APCC has staged quite a good rally recently. Despite the terrorist attack in London last week, market sentiment is still very positive right now. Inflation seems to be under control and the market is very optimistic about upcoming earnings.

In addition to last weeks positive earnings from some big companies including Apple Computer, this week will see some large earning reports from the techies: IBM, Intel, Google, Motorola and Yahoo!. The market seems very bullish right now and APCC has been following suit.

This isn't necessarily a bad thing for our position as we are long a Call Backspread, which has unlimited upside potential. But APCC had already been crawling down toward our beak even downside target of $23 and has now rallied back to $25.10, erasing our unrealised P&L and leaving our option position with a current loss of $45 per option spread. But if APCC continues to rally like this, we could be in good shape.

Here is what APCC looks like right now:

And here are the current option prices from Yahoo!

If you plug these values into the Option Trading Workbook, you will notice that Implied Volatility has risen about 10 volatility points for the $25 call option to about 34%. The realised volatility (also called Historical Volatility) has also increased slightly for the 30 day period.

We do want volatility to increase, so this is good for us, but we also need the market to move in our favour past and way beyond our break even points.

There is still 35 days left so let's see how earnings turn out this week. Stay tuned...

Update - 22nd July

APCC put on a nice rally this week - a 3% gain since this last update. The market seems very optimistic regarding the earnings announcements this week and thinks inflation (and hence interest rates) is under control. Our Call Backspread option position is now showing a profit of $40 per contract. Up from a loss of $45 last week. With our maximum loss on this trade being $200, our return on max loss is now 20%.

Here is APCC now;

And the closing option prices from Yahoo!

At this point, we can either reverse the option position and realise the 20%, or we can hold onto this trade in the hope that we might actually squeeze a little more P&L out of this position.

I think it is worth holding onto this trade as APCC is releasing it's second quarter earnings on Monday July 25. If the numbers come out unexpected, we could see a more explosive move in the stock. Hopefully, the number is greater than expected, which will send the stock higher and give us an even greater unrealised P&L.

Remember, that our initial prediction for this trade was from Travis at StocksAndOptionsTrading who had forecast APCC to reach $28.50. His method of Box Turning Points looks pretty accurate so far. Let's see...

Update - 26th July

Wow. APCC's earnings came as a real surprise to the market: 2nd Quarter revenue and Earnings Per Share (EPS) came in at 480.60 and 0.21 compared to analyst estimates of 467.40 and 0.20.

APCC spiked on the news to close up 2.30% on the day.

We are now clearly above our upper break even point of $27 and our Call Backspread option strategy is showing an unrealised P&L of $120 per spread. Based on our maximum premium loss of $200 means we have made a 60% return so far in 34 days.

Here is a summary of our position:

Short 1 August $22.50 Call Option @ 2.30 Now trading at 5.70 (-3.40)

Long 2 August $25.00 Call Options @ 0.90 Now trading at 3.20 (+4.60)

Unrealised net profit of $120 per option spread.

If you enter these closing prices into the Option Trading Workbook you will notice that implied volatility has also jumped up together with realised volatility.

Things are now looking great for us with this trade. Now we have to decide if we want to close out the position and realise the 60% gain or hold on and see how much we can squeeze out of this position.

I'm now starting to have alot more confidence in Travis' Box Turning Points system, which looks to have been spot on with picking this move in APCC.

Travis is predicting that there's still 50c left in APCC, so I think we will hold onto this position and see how far it goes.

Update - 29th July

This trade is still going very well for us. APCC finished up this week 0.11c higher than the last update and as you know, the payoff profile for a long Call Backspread means that we have unlimited upside profit potential as the market rallies, so it is probably a good idea to keep long with this position.

Here is a snapshot of our option portfolio as at Friday's closing prices:

Short 1 August $22.50 Call Option @ 2.30 Now trading at 5.60 (-3.40)
Long 2 August $25.00 Call Options @ 0.90 Now trading at 3.20 (+4.60)

Unrealised net profit of $130 per option spread (65% ROI).

Here are the Yahoo! option prices:

I still think that it is a good idea to hold onto this position a little while longer. I mean, not to be greedy, but we do have unlimitied upside profit potential and Travis has also put a $28.50 target on this stock. So we'll keep a hold of this and see if APCC can touch $28.50...

Update - 5th August

Well, we really should have taken that 65% return last week - APCC has dropped 3.8% since last week. The US market sold off Friday on the back of increased concern that the Fed is more likely to raise rates in the future as the US economy surges forward.

We are still above our break even point on this trade, but the market prices are indicating that APCC will incur further declines. Here is our option position now:

Short 1 August $22.50 Call Option @ 2.30 Now trading at 5.30 (-3.00)
Long 2 August $25.00 Call Options @ 0.90 Now trading at 2.05 (+2.30)

Unrealised net loss of $70 per option spread (-0.35% ROI).

Our position has swung from being up 65% ROI to a loss of 0.35% in a week.

The $25 call is what's hurting us. Since last Friday it has come off from $3.20 to $2.05.

Seeing as earnings are over, I think APCC is going to be at the mercy of the market as a whole, so it might be a good idea to track the Wall Street Journal for ideas until this trade expires.

Update 12th August

Our trade isn't looking too good at all now....we really should have taken the 60% ROI while we had it...APCC has been trading in a range all week and has ended up the week trading at 26.90 - just below our breakeven point.

There is still 6 days left in this trade and I am betting on the US market making more gains this week. The Wall Street Journal reports that the US market is very optimistic on US growth despite the surging Crude Oil price.

So, I think we should hang onto this trade and see what happens up until expiration this Friday.

Here is a look a our current position:

Short 1 August $22.50 Call Option @ 2.30 Now trading at 5.30 (-3.00)
Long 2 August $25.00 Call Options @ 0.90 Now trading at 1.70 (+1.60)

Unrealised net loss of $140 per option spread (-0.70% ROI).

Here are the option prices from Yahoo!

Update 13th September

I know, I am very late with this update. I'm really sorry about that, but I got married on the 27th and have only just gotten back into things.

But anyway, the 19th of August was the expiration date for our options and APCC closed at 25.76, which is pretty bad for us. We really should have taken the P&L after APCC's earnings announcement.

Here is APCC's chart as at the 19th August.

With APCC trading at 25.76, just on expiration our short call option will have an intrinsic value of 3.26. As we are short this option we will be losing $326 per contract gross. Minus the premium we received for selling the option of $230 means a net loss of $96.

We are also long 2 $25 call options. With the underlying at 25.76 means the call options will have an intrinsic value of 1.52. As we are long 2 leaves a gross profit of $152. But remember we paid $180 upfront in option premium for these two calls, so we have a net loss of $28.

All in all we are down for this trade $124. Relative to our maximum loss of $200 leaves us with a percentage loss of 62%.

Of course, I have made two very large assumptions with this trade.

1) It's probably not very likely that on expiration day I could have bought/sold out of these options at those prices. But as I wasn't near the market to know what the bid/offer spreads were at the time I just estimated the intrinsic values.

2) I also just assumed that we were not assigned on the short call options. As we were short call options that were out of the money, it is quite possible that the holder of those call options could choose to exercise as they are American Style Options.

But anyway, we now have a losing trade to add to the repertoire. Let's hope that I am better at stock picking for the next trades.

Also, if you are following Trade 4, I will update that in the next couple of days.