Trade 6 - Call Backspread
Date: 4th August 2006
Strategy: Call Backspread
Underlying: Exxon Mobil Corp (XOM)
Source: Market Club
Background and Trade Setup
Source: Market Club
The above report was taken from INO's Market Club.
I became a subscriber a couple of weeks ago and became very interested in their Smart Scan technology. Basically, INO have put together some very well known technical analysis indicators, added a weighting factor and apply it to thousands of tradable securities.
The scans are performed on equities, futures, forex and indices so there is something for everybody.
Anyway, Friday saw a very bullish signal for Exxon Mobil Corp with a reading of +100. Taking a look at the chart you can see that Exxon has made a huge rally of late, notably due to Friday's announcement that BP is shutting down its Prudhoe Bay oil field in Alaska . This is after BP discovered a corroded pipeline and a small leak in the pipes, meaning that 400,000 barrels a day of crude oil are off the markets. The expected price surge of oil has therefore boosted Exxon's share price.
With such an excessive price move, you would almost expect the share price to come off a little as the profit takers move in to realize some gains.
This is why options are such a cool investment tool.
With option combinations you can have the best of both worlds and we'll see with this example a great option strategy just suited for this.
Given that Market Club has given a +100 bullish reading for Exxon I am going to select a strategy that has a lot of upside potential but at the same time I would like some downside protection just in case things go bad.
A strategy I really like for these types of situations is the Call Backspread: Selling 1 in-the-money call option for every 2 out-of-the-money call options that I purchase.
Plugging these values into my VOptions calculator gives me the following payoff diagram:
Source: VOptions
My profit potential on the upside in unlimited, while I still have some downside protection. With VOptions, I can instantly do a download and get the last traded prices straight from the Chicago Board of Options Exchange to give me a position that looks like this: (click to enlarge)
Source: VOptions
As you can see, the ITM call that I sold is has a much higher price than the two options that I purchased. This means that overall I receive money for putting on this trade. Another term for this is a Credit Spread.
So, let's take a 3D look at our Call Backspread option combination position: (click to enlarge)
Source: VOptions
The horizontal axis simulates movements in the stock price, while time to expiration is simulated into the page i.e. the z-axis. The expected P&L at expiration is plotted on the vertical axis.
The options I chose expire on the 19 th August, so we are looking for some big moves in a short period of time. Stay Tuned. Next ->
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