Risk Reversal in Chevron

This evening’s “Options Action” on CNBC had a few interesting notes on it:

1) Volume in Bunge (BG) options were up well above normal this
week. This might be a stock to look at.

2) One of the option traders on the show is advocating setting up a collar on Amazon (AMZN). She recommends this as a way of protecting a long stock position in light of Amazon’s recent large run up.

3) Another of the traders selected a risk reversal trade in Chevron a few weeks back. The trade has played out favorably. When the trade was initiated, Chevron was at $68. The January $75 strike call options were bought for $2.10 and the January $60 puts were sold for $2.40 a contract. This means:

a) This trade is a net credit since he sold the put for a higher price than he paid for the call.

b) If the stock drops below $60 by expiration day, you will have to pay $60 to buy the stock. This means you will buy it $8 below the price of the stock when this trade was initiated.

c) If the stock rises above $75 by expiration, the put will expire worthless (you will make $2.40 a contract) and you will exercise the call to buy the stock at $75. Since you sold more premium than you paid, the trade is profitable anywhere above $75. If you had only bought the $75 call, the trade would only be profitable above $77.10 ($75 strike + $2.10 premium).

d) Fast forward to today: Chevron closed today at $76.77 a share. The $75 calls were valued at $4.05 on the close today (for a profit of $1.95 a contract). The 60 puts were valued at $0.24 a contract, for a profit of $2.16 a contract. This is a nice trade folks! It is also time to unwind it, since the short put has little profit potential left in it and the long calls will be increasingly exposed to time decay as we get closer to January.