Morning Note

August 9, 2011

US futures continue to be volatile, with Dow futures oscillating between a loss of (318) points and a gain of 324 points.

Today's main focus will be the release of the Fed statement from today's FOMC meeting, scheduled for 14:15 ET.

Treasury Auction of 3-yr notes at 13:00 ET

Greece sells €812.5M 6M T-Bills, average yield 4.85% vs prior auction 4.90%, bid to cover 3.06 vs prior 2.88

Trade of the Day: EPD March $44/$40 bull risk reversal trades 3,800x

The Trade

A trader sold 3,800 March $40 puts at $0.20 and bought 3,800 March $44 calls at $0.60 for a debit of $0.40 or $152,000.

Risk/Reward

As you can see from the risk/reward graph above, the bull reversal profits from an increase in the underlying stock. The maximum risk is being put 380,000 shares of stock if the underlying stock is trading below $40. At the close, the underlying ended the day at $42.69. The upper break even price level for this spread is $44.40. At this price level, the long calls would get exercised which would exactly offset the debit. The maximum profit potential is unlimited because we are naked long calls.

The line shown in the chart above is the upper break even price of $44.40. The 52-week range for EPD is a low $29.05 and a high of $43.35. Therefore, EPD must make new highs in order for this bull risk reversal to be profitable. We can see that the $44 level has shown resistance twice in the past 6 months. EPD will report 2010 Q4 earnings before the open on February 17th, 2011.

EPD is a North American midstream energy company that provides services to producers and consumers of natural gas, natural gas liquids, cruide oil, refined products and certain petrochemicals. EPD traded 11,077 contracts today with an average volume of 2,895.

Trade of the Day: Short YHOO stock hedged with April 18/20 Call Spreads

The Trade
An interesting and somewhat complex trade went off in YHOO today as a trader bought 46,500 April 18 / 20 call spreads for $0.30 or $1,395,000, tied to 744,000 shares of stock short at $16.45. 

Risk / Reward
Above you can see the risk reward if this trader held the position until expiration.

I personally think this trade was initiated for a few days or a few weeks.  As shown in the graph above you can see the risk reward for tomorrow.  It has a positive vega so an increase in volatility will help.  This could be a volatility play off the jobs numbers.

As time passes and we move into the beginning of March this trade really needs a move above 17.5 or below 15

In conclusion, it appears this trader expects a big move out of YHOO tomorrow after the jobs numbers or expects YHOO to break out of its current trading range over the next few months.  Obviously another possibility is that this trader already had an existing position and is just adjusting. 

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.

Risk/Reward

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.

Trade of the Day: CVS February 35/34 bull risk reversal

Today a trader bought 5,000 Feb 35 calls @ 0.65 and sold 6,500 Feb 34 puts @ .67 for a net credit of $110,500. As you can see from the risk/reward graph above, the ratio bull risk reversal has unlimited profit potential above $33.83 due to the credit received from the spread. The risk is being put 650,000 shares of stock if the underlying stock is trading at or below $34.

The chart above shows the break even price level for this spread at $33.83. As you can see, the break-even line has shown to be a support and resistance in the past.  It is also interesting to note that the current strike peg is $34 with expiration only 3 Fridays away.

I'd like this spread if I wouldn't mind owning the stock at 34. But why not sell the 37 calls too and collect some more premium?  Previous high is at $38; Maybe this trader sees CVS really ripping after their earnings report on 2/3/2010.  Its also important to note that there is a margin requirement for risk reversals.

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