A Good Example of an Option Spread Trade

05/21/2010 12:01 am EST


Shares of packing and container company Pactiv Corp. (PTV) are rallying toward their 52-week high during mid-day trading, but options volume that crossed the tape by mid-day yesterday suggested one investor is betting that the rally will not last longer than three months.

By 11:38 am ET yesterday, more than 3,300 out-of-the-money (OTM) August 25 puts had changed hands and more than 4,200 OTM August 35 calls had crossed the tape versus current open interest of 243 contracts and 27 contracts, respectively. Judging from the open interest levels, it’s likely that investors traded these options to open. A look at time and sales shows a big block totaling 2,000 August 25-35 synthetic short stock (split strikes), or risk reversals, traded thanks to an investor who was willing to risk 50 cents per spread to express bearishness on PTV. The investor appears to have bought the puts for 90 cents per contract (higher than the ask price when the trade hit the tape) and could have simultaneously sold the calls for 40 cents per contract (lower than the bid price at the time of the trade) to pay a net debit of 50 cents per spread.

Take a look at the graph below for a visual of the risk/reward dynamics of this spread trade.

Click to Enlarge

While the synthetic short stock has some similarities to a short stock position, there are nuances in the strategy due to the split strikes. Maximum gain is limited to $24.50 in the unlikely event that PTV shares drop all the way to zero. If the stock climbs higher than $35, this spread trade could produce unlimited losses. If PTV shares remain around their current level and are trading between $25 and $35 at August options expiration, the investor will lose only the premium paid, or 50 cents per spread. The investor stands to make money if PTV shares drop lower than the breakeven price of $24.50.

PTV had gained $1.59 to trade at $29.49 at the time of this writing (the stock reached a 52-week high of $29.71 on Monday, May 17). The company has not announced its next earnings release date, but the market expects the report around July 20.

By the Staff at ONN.tv

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