Exelon (NYSE:EXC) was just downgraded by Goldman Sachs - they moved their target share price to $50 from $52. Following the announcement shares sold off, and now they are trading in the area of $43.75.
I made the following trade:
- Sell to open 1 EXC JUL2010 42.5 put @ $1.50
- Buy to open 10 EXC JUL2010 50 calls @ $0.15
I wrote the stock up favorably last year, looking for a target of $66 in two years, and I have been accumulating losses on a long position. Revisions to my valuation file now show a target of $60, but the shares just keep meandering down, with low volatility and decreasing short interest.
What's in a Name?
I have seen the strategy discussed here, described variously as a bullish reversal, a split strike, or a reverse collar. I think of it as the split synthetic, under the reasoning that short a put and long a call at the same strike is a synthetic. So at different strikes then why not call it a split synthetic? I like to do it with a ratio, and the ten to one appeals to me.
The downside risk is fairly manageable. It amounts to holding a conservative, dividend paying stock at a yield of 4.9%, and a P/E of 10.4. EXC has not traded below $42.5 at any time during the past 5 years.
It seems unlikely that Exelon can make a move from where it's at now, to $50 within the 115 days till expiration. However, just eyeballing a 5 year chart, the stock has spent plenty of time, maybe 50% or so, above that level.
When to Use
I limit the use of this strategy to cases where the put sold is in the area of margin of the security, and the prices permit a net credit or a decent ratio, with more calls than puts. This case fits those standards, with the dividend putting a floor under the share price if assigned on the put. The ten to one ratio will generate profits if the stock makes a sudden upward move, and generous profits if it actually goes over $50.
"Cheap shot," may be the best name for this trade. The out of pocket cost is limited to the commissions for opening the trade, and the downside risk is limited to owning a dividend payer at a five year low price, which always has the possibility of making a profit.
Disclosure: Author long EXC