Thursday afternoon (Jan. 19, 2012), CNBC's Pete Najarian reported that he'd seen a sizable uptick on call options on Dow Chemical (DOW). Specifically there was unusual volume in the Feb. 35 calls when the stock was around $33.00. With Dow earnings scheduled for release on Feb. 2, one or more big-money investors are expecting a pop prior to the Feb. 18 expiration date.
I'm personally not a fan of naked OOM calls - even when they're selling for only $0.43 like the DOW Feb. 35 calls. So here are two other option strategies that better suit my risk-reward parameters - and perhaps yours as well.
The more conservative approach would be to employ a buy-write strategy, and the table below illustrates several potential buy-write trades with February, March, and June expirations.
Here's how to read the table: Dow closed at $32.98 on Thursday. You could have sold a Feb 35 call for $0.43. If Dow were at or above the strike price of $35.00 at expiration, the stock would be called away and you would enjoy a return of 7.4% (the $0.43 option premium plus the cap gain of $2.02). If Dow stays below the strike price, you could sell another call and receive another premium. (Note: If you were to write June options, you'd also collect a $0.25 dividend that would further increase your return, but is not included in the numbers provided below.)
An alternative approach to profit from Dow's potential upside is a vertical spread. It's certainly a riskier play, but also offers considerably more upside. The following table illustrates two bull spreads expiring in both March and June.
Here's how to read this table: With DOW at Thursday's close of $32.98, you could have bought a March 31 call for $2.95 and sold a March 35 for $0.80. The cost of the trade and your maximum loss would be $2.15. Your maximum return would equal 86.0% (the proceeds of $4.00 minus the cost of $2.15). Dow would need to be at $33.15 at expiration for you to break even on the trade (the long strike of $31 plus the $2.15 cost of the trade). Each of the four scenarios is structured so that the break-even price point is reasonable, thereby reducing the chance of loss in the trade.
Please keep in mind that all these numbers would be reduced by transaction costs.