Tags
Butterfly, Creative, Invest, Investing, Market, Money, New, Options, Profit, Risk, Stocks, Wrestling
New Changes-
I have decided to add a new more educational piece to my blog. On occasion, I will discuss different terms of the market.
Options Week- This week I will be doing something different and will be giving an example of options that could be performed on two of the stocks that I have reviewed. I will be discussing how to use a bull spread with World Wrestling Entertainment as an example and how to perform a butterfly spread using Merrimack Pharmaceuticals as an example.
WWE-
On WWE I will be performing a bull call spread. A bull call spread is useful when you expect the price to go up a little, but not a lot.
The first stock that I will be looking at stock options on is World Wrestling Entertainment. When I reviewed this stock last week, I talked about how I believed it was very undervalued and how its target price is way above its current stock price. Because I believe the stock price will go up and would like to take advantage of this, I will first look at buying a call. I will be looking at October 2014 calls in this case. The call I have chosen to look at is a call at a strike price of $12.50 with a premium of $1.21. In purchasing 1000 of this call, the Break Even Point would be $13.71 which is well under the target price of $23.19. Every dollar increase after the BEP would result in an increase of $1000. If WWE was to reach the target price of $23.19 the profit would be $9480. This seems like a terrific option to take advantage of and could gain huge benefits.
However if the stock were to not reach the strike price, the investor would lose the initial $1210 spent as a premium. If you believe strongly in the stock this may be a risk you would take, but if you want to decrease risk, you could do so by selling a call at a higher price. This is called a bull call spread and would decrease risk. The call I would choose to sell has a strike price of $14 and a premium of $.89. By combing these two options you can decrease the potential loss. Doing so however would decrease the potential gain as well. By combing, the maximum loss would be $320 if the price dropped to zero (highly unlikely). If the price was to rise above $14 the profit would be set at $1180. This is a much safer option and would also have a lower break even point at $12.82. The following is the graph for a bull call spread. The blue lines represent the calls whereas the red line represents profit.
Merrimack Pharmaceuticals-
I will be showing the reader how to use a butterfly spread in this situation and will do so on Merrimack Pharmaceuticals. A butterfly spread involves four contracts and three strike prices. The investor buys a contract (call or put, doesn’t matter which) at the lowest strike price and the highest strike price, and then sells two contracts at the middle strike price. Butterfly spreads tend to have very minimal risk and are useful when you do not expect the price to deviate much from its current position.
Merrimack is currently priced at around $8.00. Because it is a pharmaceutical company and will likely not have any drugs come out in the near future, its stock price will likely not rise that much. Because of this, a short term butterfly spread could lead to a small profit.
In this situation, my three strike prices for Merrimack for July calls are at $6, $8, and $10. The premiums respectively are $1.60, $.83 and $.20. Because of this, my initial cash flow after buying 1000 calls at the $6 strike price, 1000 calls at the $10 strike price and selling 2000 calls at the $8 strike price is -$340. This also happens to be the maximum loss the investor can have as they due to their butterfly spread; they cannot lose more than the initial cash flow from the premiums. In this case, the maximum profit would occur at the second strike price and current price of $8 where the investor would gain a $1660 profit. The two break even points in this situation would be $9.66 and $6.34. Any price in-between these two would yield a profit. If you are an investor who after looking at Merrimack Pharmaceuticals or any other company, decides they will likely stay around their current price, then performing a butterfly spread could be a smart option for you. The blue lines represent the calls whereas the red line represents profit. Remember that the blue line in the middle is steeper as it is 2x the calls of the other blue lines.