Ratio Call Spread as a Stock Repair Strategy 12-08-2010

Cusick's Corner
The market found itself near the morning highs and that's not surprising for today's range bound trade. As a matter of fact, a lot of the trade today was revolved around strategies that look to take advantage of premium selling, while adding upside potential without extending capital risk. Ratio spreads are often executed against stock that is already owned, where the strategist sees some potential upside but feels there is a ceiling. For the ratio call spread, the strategist sells 2 calls at a higher strike price vs. where the market is currently trading, against stock already owned and also against a long call strike that is usually at the same price to where the stock is trading. The ratio call spread can also be used as a repair strategy and if the upside gets more challenged but still the prominent trend, the ratio call spread repair strategy can potentially allow a strategist to participate in upside at a higher multiple than the general covered call writer. See you Midday.

Stock market averages overcame early weakness and finished with modest gains Wednesday. With no economic news on the calendar, the focus in morning trading was back on the action in the bond pits. After a rout Tuesday, Treasurys were falling hard for a second day on yesterday's news of tax cut extensions. The yield on the benchmark ten-year Treasury was less than 3 percent late-Monday, but rallied beyond 3.3 percent in afternoon trading Wednesday. However, the situation had stabilized by midday and the yield on the ten-year finished at 3.26. Meanwhile, an encouraging 2011 forecast from Home Depot (HD) as well as strength in the financials –JP Morgan (JPM) and BofA (BAC) – helped keep the Dow above water. At the end of the day, it was a relatively quiet trading session. The industrial average traded in a 61-point range and added 13 points. The tech-heavy NASDAQ added 10.7.

Bullish Flow
Ford Motor (F) gained 13 cents to $16.69 and 103,000 calls traded on the automaker. The volume isn't unusual, but it was 3X the day's put volume and included a large block of 12,500 January 17.5 calls at 43 cents per contract. The market for these calls was 40 to 41 cents at the time and so this trade printed above the asking price. It was likely a call buyer. At the end of the day, 21,100 traded. Meanwhile, the December 17 calls, which traded 24,430X, were the day's most actives in Ford. Shares have performed well lately, gaining 18 percent since earnings were reported on 10/26. Some investors are probably buying out-of-the-money calls as a way to play the stock in the weeks ahead. However, December options expire at the end of next week.
Bullish order flow was also seen in Fortune Brands (FO), Sara Lee (SLE), and Walgreens (WAG).

Bearish Flow
Cemex (CX) saw large blocks of puts traded late-Wednesday. Shares finished the day down 6 cents to $9.85 and in afternoon action a block of 13,222 January 2012 $5 puts traded at 32 cents and a block of 13,222 January 2013 $5 puts at 77 cents. The spread traded 1,000 more times and volume in both contracts surpassed 14,222 on the day. Looking at the open interest, this spread looks like a roll, where the strategist is selling to close a position in the Jan 12s to open a new one in the Jan 13s. It might be a shareholder using deep out-of-the-money puts to hedge a position in shares of the Mexican cement company. They are extending the hedge an additional year to the longer-term 2013 puts.

Bearish flow also picked up in DR Horton (DHI), Dollar General (DG), and KLA Tencor (KLAC).
Index Trading

It was a day of relatively quiet trading today. The S&P 500 Index (.SPX) traded in a 9.4-point range and finished up 4.53 points to 1,228.28. Meanwhile, the CBOE Volatility Index (.VIX) lost .25 to 17.74. 439K calls and 533K puts traded across the SPX, VIX and other index products. The biggest options trades of the day were in the VIX after the January 37.5 – February 35 call spread was apparently bought at 60 cents, 12,584X. In this spread, the strategist apparently bought 12,584 Feb 35s at 93 cents each and sold 12,584 January 37.5 calls at 33 cents. It might be a roll out of Jan and into a Feb and or a bet that VIX will hold below the mid-30s through mid-January and then see a spike from that point forward.

ETF Trading
An interesting spread traded in the iShares Emerging Markets Fund (EEM) late-Wednesday. Shares finished down 30 cents to $46.54 and one strategist sold the December 46 straddle (puts and calls) at $1.50 and bought the December 45 put – 47 call strangle at 71 cents, 5000X. This trade is also known as an iron butterfly, where the body (46s) were sold and the wings (45s and 47s) were bought. The strategist collected a net credit of 79 cents (excluding commissions), which they keep if shares fall to $46 at the expiration. The range of profitability is between $45.21 and $46.79. 21-cents, plus commissions, is at risk if shares move outside the higher (47) and lower (45) strikes of the two wings.