Thursday, February 3, 2011

Trade of the Day: JPM Jan 2012 40/30 ratio put spread

The Trade
Today, a trader bought 25,000 Jan 2012 40 puts @ 3.05 and sold 50,000 Jan 2012 30 puts @ 0.95 for a net debit of 2,875,000.

As you can see from the risk/reward graph above, the ratio put spread has limited risk and limited profit potential, with a bearish bias. The maximum risk for this spread would occur if the underlying stock goes to zero. The maximum risk would therefore be $52,875,000 in this situation. The max profit for the spread would occur at an underlying stock price of $30. At this price level, the short puts would expire worthless, and the long puts would be exercised. The max profit would therefore be $22,125,000. The break even price level in the underlying stock is 38.85, which is the higher strike price minus the debit. Ratio put spreads are a popular and cheaper way to hedge long stock vs buying a put vertical as long as the trader understands the increased risk/reward profile.

This bearish ratio put spread would be profitable if the underlying stock went below $38.85. JPM last dipped below the $39 level in November of 2009. It's interesting to note that JP Morgan hosts an analyst day on the 14th of February.

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