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Breaking down a hypothetical trade on YELP
Yelp Inc (NYSE:YELP) has had an abysmal past few months. Since touching a record high of $101.75 in March, the shares have plummeted more than 40% -- including nearly 3% today -- to their present perch at $60.55. In fact, in recent weeks, the consumer review stock has struggled in the $61-$62 area, which corresponds with YELP's descending 20-day moving average, at $61.46. The question we'll be asking today is: How can someone use options to capitalize on this negative price action?
There's no single answer to that question. Nevertheless, this afternoon, we'll be looking at one possibility among many -- namely, the short call spread. In a nutshell, this strategy consists of selling to open one out-of-the-money (OOTM) call, and buying to open one deeper OOTM call.
For clarity's sake, we'll frame this discussion around an imaginary trader named Mack. Amid expectations for the aforementioned technical resistance to hold in the short term, Mack sells to open one December 62.50 call at the bid price of $2.50, and simultaneously buys to open one December 70 call at the ask price of $0.90. This results in an initial net credit of $1.60, or $160 (one pair of contracts * 100 shares per contract).
By implementing this strategy, Mack is gambling on YELP remaining at or below the lower strike through the close on Friday, Dec. 19, when the back-month options expire. If this happens, both contracts will expire worthless, and he will retain the initial net credit as his maximum potential reward. However, even if the shares topple $62.50, Mack will profit at expiration, so long as YELP finishes below breakeven at $64.10 (sold strike plus initial net credit).
North of breakeven, losses will begin to accrue. However, the long call position ensures that Mack's losses will be capped if YELP hits $70 -- unlike a vanilla short call strategy, where losses are theoretically unlimited. (On the downside, buying the call lowered the potential profit on the short trade.) Specifically, Mack's maximum potential loss is $5.90 (difference between the strikes, less the net credit), or $590.
Having explained all that, let's consider a couple of hypothetical at-expiration scenarios. Suppose YELP settles at $63 at expiration. In this case, Mack would still make $1.10 (breakeven price less actual price), or $110 -- less any transaction fees -- on the two-legged trade.
On the other hand, suppose Yelp Inc (NYSE:YELP) is sitting at $65 at expiration. In this case, Mack's loss would be $0.90 (actual price less breakeven price), or $90, plus any transaction fees.