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Options Lab: Plug Power Inc (PLUG)

Breaking down a hypothetical trade on PLUG

by 7/29/2014 11:26:58 AM
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Plug Power Inc (NASDAQ:PLUG) has nearly quadrupled in value this year, and is currently hovering near $5.92. Today, in fact, the shares have tacked on more than 7%, after Wal-Mart Stores, Inc. (NYSE:WMT) ordered additional GenKey units from the alternative energy firm, and Cowen raised its price target on PLUG to $8 from $6. In sum, PLUG's outlook appears pretty rosy. The question we want to ask today is: How can we capitalize on the stock's potential future gains using options? In order to answer this question, we'll study the case of a hypothetical options trader named Mike, and a strategy called a long (or bull) call spread.

Daily Chart of Plug Power Inc (PLUG) since April 2014

Based on everything stated above, Mike decides to wager on a continued rally for Plug Power Inc over the next few weeks. Therefore, he buys to open 10 August 6 calls, at the ask price of $0.44 each, or $440 total (premium paid * number of contracts * 100 shares per contract). However, Mike doesn't think the shares will topple $7 by options expiration at the close on Friday, Aug. 15, so he simultaneously sells to open 10 August 7 calls, at the bid price of $0.16 apiece -- thereby collecting $160. Doing so allows him to offset a portion of the money he spent on the long calls, such that his initial net debit -- which also represents his maximum risk on the trade -- is $0.28 per pair of contracts, or $280 total (premium paid less premium collected).

In order to profit at expiration, Mike needs PLUG to rally beyond $6.28 (bought strike plus initial net debit) by front-month options expiration. Additional gains will accrue north of this breakeven mark. However, due to the sold calls, potential profits are maximized once the shares hit $7 (whereas potential profits are theoretically infinite using a "vanilla" long call strategy). To put things further in perspective, the profit potential for this bull call spread is $0.72 per pair of contracts (difference between the strikes, less the initial net debit), or $720 total. This is more than 2.5 times Mike's initial net debit of $280, which he'll lose if the stock is resting at or below $6 when the closing bell sounds on Aug. 15.

For even greater clarity, let's run this trade through a couple of hypothetical scenarios. For example, suppose PLUG closes at $6.35 when the front-month contracts expire. In this case, Mike will earn $0.07 per pair of contracts (actual price less breakeven price), or $70 total ($0.07 profit * 10 pairs of contracts * 100 shares per contract), less any brokerage fees. Alternatively, suppose Plug Power Inc (NASDAQ:PLUG) is resting at $6.05 at August options expiration -- that is, the contracts are in the money, but below breakeven. In this case, Mike would lose $0.23 per pair of contracts, or $230 total (plus any brokerage fees).

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