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Smith & Wesson Holding Corp (SWHC): The Ins and Outs of a Long Call Spread

One Smith & Wesson Holding Corp bull took the conservative route

by 8/27/2014 11:13:32 AM
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In the wake of a fiscal first-quarter revenue miss, a downwardly revised full-year outlook, and no fewer than four price-target cuts, Smith & Wesson Holding Corp (NASDAQ:SWHC) has plunged 13.4% today to $11.34 -- its lowest level since late February. Amid today's post-earnings dive, the stock has been placed on the short-sale restriction list, and options volume has soared to 20 times what's typically seen at this point in the day.

Calls are the options of choice, however, and are outpacing puts by a nearly 2-to-1 margin. Diving deeper reveals that one speculator, in particular, is betting on SWHC to rebound over the next two months. Believing this bounce could stall out near the $13 mark -- an area that has recently served as both support and resistance for the stock -- she is taking a more cautious approach to her bullish bet by pairing a long call with a short call in the October series of options.

Specifically, four blocks totaling 1,300 contracts changed hands earlier at SWHC's October 12 and 13 calls. The lower-strike calls were bought at an ask price of $0.45 apiece, while the higher-strike calls were sold closer to the bid, for $0.15 each. Volume outstrips open interest at each strike, making it safe to assume a long call spread was initiated for an initial cash outlay of $0.30 per pair of contracts, or $19,500 (650 [1,300/2] contracts * net debit of $0.30 * 100 shares per contract).

By selling the higher-strike call, this speculator has not only reduced her cost of entry, but also the breakeven mark. For instance, had she just bought the October 12 call outright, the at-expiration breakeven mark would be $12.45 (strike plus premium paid). Meanwhile, breakeven for this long call spread is a slimmer $12.30 (bought strike plus net debit).

By coupling the short call with the long call, she has also reduced her risk on the trade to $0.30 from $0.45, should SWHC settle south of $12 at the close on Friday, Oct. 17 -- when back-month options expire. However, she has also cut her maximum profit potential to $0.70 (difference between the two strikes less the net debit), no matter how far Smith & Wesson Holding Corp (NASDAQ:SWHC) is sitting above $12.30 at October options expiration. Had she solely initiated the long call, gains would be theoretically unlimited past the breakeven mark of $12.45.

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