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Facebook Inc (FB): A Lesson in Ratio Spreads

One FB options trader is gambling on a slow trek to new highs

by 8/15/2014 11:09:32 AM
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Since its late-July post-earnings bull gap into record-high territory, Facebook Inc (NASDAQ:FB) has taken a breather on the charts, with the shares last seen flirting with $74.28. However, one confident trader expects FB to resume its quest for new highs, but sees a round-number ceiling in the short term.

Instead of simply buying FB calls outright, or implementing a long call spread, the speculator yesterday took a higher-stakes approach by initiating a call ratio spread. Specifically, it looks like the investor bought to open 3,465 October 75 calls for $3.42 apiece, and simultaneously sold to open twice as many October 80 calls for $1.59 apiece, resulting in a net debit of $0.24 ($3.42 - [$1.59 x 2]) per trio of options.

Had the trader just purchased the 75-strike calls, his net debit -- and maximum risk -- would be $3.42 per contract, and his breakeven would be $78.42 (strike plus premium paid) -- 5.6% north of the stock's current perch -- at October options expiration. Reward, meanwhile, would be theoretically unlimited to the upside.

Had he hedged the bought calls with an equal number of 80-strike calls, his net debit would be $1.83 ($3.42 - $1.59) per pair of contracts, which he'd forfeit if FB remained south of $75 through the options' lifetime. His breakeven would be lower than that of the vanilla call, at $76.83 (bought call strike plus net debit) -- representing a 3.4% pop -- but his reward would be capped at $3.17 (difference between strikes minus net debit), no matter how high FB should soar atop $80.

By writing twice as many calls at the 80 strike, the speculator nearly funded his entire purchase of the 75-strike calls. His net debit of $0.24 represents the most he can lose if FB stays beneath $75, and he now stands to make money as long as FB is perched atop $75.24 (bought strike plus net debit) -- within a point of the stock's current price -- at October options expiration. His maximum reward, meanwhile, is even greater than that of the vanilla call or long call spread, at $4.76 (difference between strikes minus net debit), should FB settle right at $80 when October options expire.

However, by implementing the ratio spread, the trader also upped his risk significantly, as half of the sold calls are "naked." As such, his maximum risk on a move north of $80 -- in territory not yet charted by Facebook Inc (NASDAQ:FB) -- is theoretically unlimited.

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