Roughly 40,000 Baidu Inc (ADR) (NASDAQ:BIDU) calls traded last Friday, compared to an expected daily volume of 25,000. Accounting for a sizable portion of the activity was a call ratio spread, which was initiated at the July 160 and 170 strikes. In other words, one confident speculator placed a bullish bet on the shares, expecting BIDU to rally modestly within the next two-plus months.
Taking a closer look, Friday's trader sold to open 9,000 July 170 calls at the bid price of $3.20 apiece, and simultaneously bought to open 4,500 July 160 calls at the ask price of $6.25 each. In other words, the speculator wrote twice as many contracts as he purchased, representing a 2:1 ratio -- hence, the term "call ratio spread."
In so doing, he collected a net credit of $0.15 -- the premium collected of $6.40 ($3.20 * 2) less the premium paid of $6.25 -- for every three contracts traded. Based on the total size of the transaction, this works out to an initial net credit of $67,500 (net credit of $0.15 * 4,500 long calls * 100 shares per contract), which will be secured if Baidu shares are sitting at or below $160 at the close on Friday, July 18, when the options expire.
With each step north of $160 the underlying takes during the option's lifetime -- up to the $170 mark -- the trader will rack up additional profits. However, because the 170-strike calls were sold, the speculator's maximum potential gain is capped at $10.15 per spread (difference between the strikes, plus the net credit). Again, based on the size of the trade, this equates to a maximum potential profit of more than $4.5 million ($10.15 * 4,500 long calls * 100 shares per contract).
If BIDU shares rally beyond $170, however, the trader's profits will begin to erode, due to the sold calls. Ultimately, the transaction will reach breakeven at $180.15 (sold strike plus the maximum potential profit); beyond that point, losses will begin to accrue. In fact, since only half of the sold calls are covered, the trader is exposed to theoretically unlimited risk. Thus, he must be confident that the stock will rally no more than 16.5% (from its current perch at $154.68) by July options expiration.
At last check, delta on the July 180 call -- the strike nearest the breakeven mark -- stood at 0.17. Simply stated, the options market is currently pricing in a less than 1-in-5 chance that Baidu Inc (ADR) (NASDAQ:BIDU) shares will be sitting at or near the aforementioned trader's "danger zone" two-plus months from now.
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