Breaking Down a Three-Legged Spread on Baidu, Inc. (BIDU)

04/23/2010 12:01 am EST

Focus: OPTIONS

Elizabeth Harrow

Financial Analyst, Schaeffer's Investment Research, Inc.

So, I'm way late to the party on this, but I just uncovered an interesting three-legged spread strategy that crossed the tape on Baidu, Inc. (BIDU) during the course of Tuesday's trading. If you'll excuse my tardiness, I think this skeptically skewed options tactic is worthy of a closer look.

Check it out: In afternoon trading, a block of 171 May 710 calls traded near the bid price, suggesting they were sold. This block traded simultaneously with a matching cluster of 171 May 600 puts, which changed hands near the ask, indicating they were purchased. At the same time, a block of 171 May 580 puts traded near the bid, revealing they were most likely sold. With BIDU trading at $629 today, all of these options are out of the money.

BIDU price chartBasically, this is a long put spread with a short call attached. By writing the May 710 calls and the May 580 puts, the trader effectively offset the cost of the purchased May 600 puts, and then some. The sold contracts netted a combined credit of $17.39, while the purchased puts cost $16.89. So, this three-legged spread resulted in an upfront net credit of $0.50.

The best-case scenario here would be for BIDU to settle squarely at $580 upon front-month expiration. The sold calls and puts could be allowed to expire worthless, while the trader could sell to close the purchased puts to rake in the maximum possible profit of $20 (plus the initial net credit).

Meanwhile, potential losses are theoretically unlimited, due to the presence of that (presumably naked) call at the 710 strike. If BIDU should rally beyond the $710 region during the next month or so, the trader's losses could add up fast.


Click to Enlarge

This could be a pre-earnings play on BIDU, which is slated to report its first quarter results after the close on Wednesday, April 28. From a technical perspective, it's hard to make a case for this bearishly biased spread—the stock is up 54.6% year to date, and it's holding steady above short-term support at its ten- and 20-day moving averages.

By Elizabeth Harrow of Schaeffer’s Trading Floor Blog

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