How Spreads Can Save Your Tail

Sep.16.12 | About: Philip Morris (PM)

As a holder of Altria Group Inc. (NYSE:MO), I have been a natural fan of tobacco stocks and their juicy dividend increases over the years. Upon doing my natural research of MO and the overall smokin' performance of the industry as a whole, I noticed Phillip Morris International Inc. (NYSE:PM) was due for its usual September dividend boost. I researched the last several increases and saw impressive gains following each announcement (click to enlarge images):

yahoo/financeClick to enlarge

Believing PM would indeed boost the dividend again, I decided to attempt to harness the coinciding stock move as seen in the past. Not wanting to overweight my portfolio with more tobacco shares, I decided to utilize a call spread instead, which requires less capital than getting long shares or buying calls outright.

Call spreads are when you get long a call, then sell a higher strike in tandem, which lowers the total cost of the trade, but also restricts some upside as well. As I will explain later, this higher strike can be utilized when your timing is off on the trade.

The Call Spread:

Action: Option Strike Premium Cost
Bought to Open Sept 22 '12 87.50 1.91 -$191
Sold to Open Sept 22 '12 90 .53 +$53
Total Cost of Trade(max. risk): 1.38 -$138
Click to enlarge
Max Potential Profit: Share Price Needed: Calculation:
$112 89.99 90-87.50-1.38=1.12
Click to enlarge

I opened this call spread on September 7th, when PM was trading at around 89.00/share. In order to turn a profit, I needed PM to appreciate only slightly higher, since my 87.50 strike calls were "in the money". To achieve maximum profit, I would need PM to appreciate only 1%, from 89.00 to just shy of 90.00.

What Went Wrong:

I was a little premature with my timing. I enacted the spread on September 7th, a full 5 days before the eventual announcement (see "K" on chart), which ate up 30% worth of time value on the contracts. (September 22-September 7= 15 days. 5/15 days = 1/3). In addition, shares declined almost immediately following my initial purchase. To help relieve this devastating downtrend and lack of good timing on my part, I decided to buy back the 90 strike call I sold, to help lock in gains achieved on this half of the spread. I bought back the 90 strike for only .12 in premium around the time of the dividend announcement:

yahoo/finance

To my relief, PM raised the dividend 10% a short time after, however the stock still didn't move as much as I had hoped. In admission of defeat, I sold to close the 87.50 strike the following day, September 13th, for a disappointing 1.88 in premium. I was a little disgusted, but also thankful I utilized a higher strike, which ultimately accounted for 100% of my gains on this trade:

87.50 Strike 90 Strike
Opened 1.91 .53
Closed 1.88 .12
Total Gain -.03 +.41
Net Gain: $38
27% (38 gain/138 cost)
Click to enlarge

Admittedly, this was a poorly timed trade. Checking today, if I held on to the 87.50 strike, I possibly could have made more profit if I was a little more daring. However, with the risk/reward voice in my head, I decided to take my money and run on what turned into a failure of a trade.

Final thoughts:

Utilizing a call spread enabled a more forgiving exit of this failed trade. By legging out of the short call, I was able to manage a small gain without having to cost average down, which at times can enhance risk. I used history as my guide on this trade, but I suppose history doesn't always repeat itself? However, I still plan on using more call spreads in the future as a risk adverse way to get long while putting minimal capital on the table.

Disclosure: I am long MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.