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Options Lab: The Dow Chemical Company (DOW)

Breaking down a hypothetical trade on DOW

by 7/23/2014 10:47:00 AM
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The Dow Chemical Company (NYSE:DOW) has been locked in a long-term uptrend, adding nearly 54% on a year-over-year basis, and riding atop support at its 50-day moving average. Today, in fact, the shares have tacked on an additional 1.6% to hover at $53.11, following this morning's second-quarter earnings beat. As such, DOW options are trading at double the average intraday pace.

But how, exactly, does one use options to bet on a stock's direction? Well, let's walk through a hypothetical trade involving DOW, and a certain trader -- we'll call him Mike -- who thinks the shares will continue to rise through the end of the week.

Daily Chart of The Dow Chemical Company (DOW) since July 2013 With 50-Day Moving Average

While traditional options expire at the close of the third Friday of each month, Mike wants to target extremely short-term gains, in an attempt to capitalize on Dow Chemical's post-earnings momentum. Therefore, he decides to purchase a weekly call -- specifically, the 7/25 54 strike, which expires this Friday evening. In so doing, Mike's expressing optimism that the stock can sustain its ascent through week's end.

In order to buy the weekly call, Mike pays the option's ask price of $0.12. However, because each contract represents 100 shares of the underlying, his initial cash outlay works out to $12 ($0.12 premium * 100 shares per contract). It's important to note that this also represents his maximum risk on the trade. That is, if Dow Chemical finishes this Friday below $54, Mike will part with the $12 he paid to initiate his long call position.

On the other hand, in order to make money at Friday's close, Mike needs the underlying to take out the breakeven mark of $54.12, or the strike plus the initial premium paid. Beyond this level, he will reap theoretically unlimited gains, as the profit potential on a "vanilla" long call position is capped only by the price of the underlying.

To make sure we're clear, let's run this trade through a couple of realistic scenarios. Suppose DOW shares are resting at $54.03 this Friday -- this would bring the option into the money. However, because the stock price is still $0.09 below the breakeven mark of $54.12, Mike would lose $9 ($0.09 difference * 100 shares per contract), plus any brokerage fees.

Alternatively, suppose shares of the The Dow Chemical Company (NYSE:DOW) finished the week at $54.50, or $0.38 above breakeven. In this case, Mike would make $38 -- the difference between the at-expiration breakeven price and the actual expiration price, times 100 -- less any brokerage fees. To put it differently, that's a roughly 217% return on Mike's initial $12 investment.

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