Trade 5 - 19th December 2005

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Strategy: Put Backspread

Underlying: Pfizer (PFE)

Background and Trade Setup

On the back of Pfizer's explosive move over the last couple days, I thought it would be a good time to put on an option bet.

Pfizer shares rocketed over 7% due to a patent victory on its biggest selling drug, Liptor. It is the second large gain of its kind in a week as investors were relieved of nervousness surrounding this patent issue.

If you're keen on reading up a bit more on Pfizer's battles, check out The Wall Street Journal Online. If you live in the US, you can get a free trial by clicking here.

Anyway, here is today's Pfizer chart.

I'm thinking that this sharp up move is over done. In the short term, I expect Pfizer to come off from these levels to, say, around $23 to $23.50 a share.

But I'm also a little cautious on the upside...in case more positive news surfaces, which could drive the share price even higher. I am more confident of a downward move but I still want to make money if the market rallies. The perfect option strategy for this idea then is a Put Backspread.

Here is a snapshot of the closing prices for Pfizer options as at December 19:

Using the Option Trading Spreadsheet from this site, I figured the best options to use were the $22.50 and $25.00 strikes.

The $22.50 put option is currently trading at 0.15 and the $25.00 put is trading at $1.

A Put Backspread is constructed by selling 1 ITM put option for every 2 OTM put options bought. So, our option strategy looks like this;

Long 2 $22.50 Put Options @ $0.15
Short 1 $25.00 Put Option @ $1.00

Because these options have a contract size of 100, means that we pay $30 for the long $22.50 put options and receive $100 for selling the $25 put option. Net, we receive $75 up front for putting on this option spread.

Using the Option Trading Spreadsheet the diagnostics for this option trade are:

Max Profit: Unlimited on the downside, limited to $70 on the upside.
Max Loss: $180 when the stock is trading at $22.50 at expiration.
Breakeven Points: $20.70 and $24.70.

Let's see how this trade goes. Stay tuned. Next>>