This setup offers a potential 13.6% return by January

Another tanker to spread

Shares of Waters Corp. (WAT | Quote | Chart | News | PowerRating) fell sharply on a sales shortfall warning and an announcement of a “continuation of the challenging business conditions” ahead by management. The news sent the stock price 10% lower to 37.25 Friday morning. This sets up another nice “not likely to go zone” trade for writing an out-of-the-money call credit spread (bear call spread) with the short strike near or above the pre-gap close price. The technical conditions of the stock look weak, as well.

Figure 1 – – Generated with OptionVue 5 Options Analysis Software. Gap down of Waters Corp. following earnings shortfall. “Not likely to go zone” is highlighted in yellow, which is at or above pre-gap close price.

Figure 1 contains the price chart for WAT showing the pre-gap area (not likely to go zone) and the current price as of the time of this writing (at 36.25).

Based on current market prices at the moment, we could sell a January call spread, but I will add an extra long leg to push the negative position delta lower for some additional cushion against a move back up to the pre-gap close levels so this trade would be actually be a call ratio credit spread, which is presented in Figure 2 with legs, prices and net credit.

Strikes Contracts Prices Value Net Credit
Jan 40 Call -1 90 $90 --
Jan 45 Call +2 15 $30 $60

Figure 2 – January call ratio spread (selling one Jan 40/buying 2 Jan 45 calls) price when the underlying stock price for Waters Corp was at 36.25

As always, you will want to close this trade if the spread price doubles (i.e. at $120), or if the short strike is touched, whichever comes first. Otherwise, the trade should be held open until expiration, or until the spread drops to at least 25% of the price it was sold for, if you want to use a profit target. I tend to use my judgment here, so if the price is considerably lower from the point of entry, I may not close it since it is almost assured of expiring out of the money. But if technical conditions begin to change, I may take profits early if possible.

Figure 3 – Generated with OptionVue 5 Options Analysis Software

Figure 3 shows the zone of profitability, with upside breakeven at 40.60 (the short strike plus premium collected), with no downside risk, and maximum profit occurring at any point under 40 by expiration of this spread on January 21. As you can see, the addition of the second long leg (commissions are not counted here but should run about $3.00 to initiate the positions), the upside profit/loss in pre-expiration profit/loss time frames (dashed lines) is flattened out great than a 1 x 1 call spread.

If this spread expires worthless, it will generate a profit of 13.6%. Remember to risk only a small fraction of your capital on each one of these types of trades to keep risk well diversified.

I hope this gives you some trading ideas you can use and from which you can learn.

Enjoy the weekend.

Cheers
John Summa

John F. Summa is Founder and President of OptionsNerd.com, and a registered Commodity Trading Advisor (CTA) with the National Futures Association (NFA). Founded in 1998, OptionsNerd.com offers trading seminars and tutorials to options traders, futures and option trading advisories and managed futures and options CTA account services. Mr Summa's trading articles have appeared in Technical Analysis of Stocks & Commodities magazine, as well as Active Trader Magazine, Options Trader Magazine, Futures Magazine, Stock, Futures & Options Magazine, and Investopedia.com. He coauthored Options on Futures: New Trading Strategies and Options on Futures Workbook (John Wiley & Sons, 2001) and more recently wrote the groundbreaking book, Trading Against The Crowd: Profiting From Fear and Greed in Stock, Futures and Options Markets (John Wiley & Sons, 2004), which includes Mr. Summa's innovative quantitative bear and bull news-flow Contrarian indicator. Mr. Summa is a PhD-trained economist and operates a delta-neutral options trading CTA program.