Targeting with options

Traders who saw auto parts company LKQ (LKQ) all over Monday’s LiveAction scans for unusual options activity likely had little problem identifying the trades that bumped volume to roughly 50 times its daily average. With the stock a little below $29 shortly after the open, prints of 7,300 and 7,000 contracts appeared in the November $32.50 and $37.50 calls:

While the trades could have been unrelated, the fact that 7,000-contract trades occurred in both options at the same time suggests a connection. One of the more plausible explanations is that a large trader established a “vertical” spread—that is, the simultaneous purchase and sale of options with the same expiration date but different strike prices.

In this case, some observers would suspect this vertical spread was a “bull call spread”—that is, the trader bought the lower-strike $32.50 calls and shorted the $37.50 calls. As the following profit-loss profile shows, the combination creates a limited-risk, limited-reward position:

Like a long call, a bull spread’s risk is limited to the cost of establishing the position (the long-call premium minus the short-call premium). The bull spread essentially offers a less-expensive way to profit on a potential up move. The trade-off is that the spread’s upside is limited to the difference between the two strike prices, minus the spread’s cost. The maximum profit (at expiration) occurs if the stock closes at the upper (short) strike price, in which case the short option expires worthless and the trader gets to keep all of the collected premium.

While LKQ traded higher on Monday and Tuesday, it’s still near its five-year lows and a little more than 30% below its December 2021 all-time high. While a trade that depends on the underlying stock making a roughly $3.50-$8.50 up move over the next five weeks may seem like a modest proposition, that represents an 11%-29% rally. At expiration, the spread would have the potential to produce a profit if LKQ closed somewhere between the two strike prices:

Of course, it’s possible that the initiating trader was a seller rather than a buyer of the spread (long the $37.50 call and short the $32.50 call), which implies an expectation that the stock will remain below the lower strike price until expiration.

Whether LKQ’s late-October earnings release factored into the trader’s decision is an open question. The stock’s earnings-day moves have mostly been to the downside (including in July) since the stock entered its current downtrend in early 2022.

Today’s earnings include: Abbott Laboratories (ABT), Bank of America (BAC), J.B. Hunt Transport (JBHT), Morgan Stanley (MS), United Airlines (UAL).

Today’s numbers include: mortgage applications (7 a.m.), Empire State Manufacturing Index 8:30 (a.m.).

Click here to log on to your account or learn more about E*TRADE's trading platforms, or follow the Company on Twitter, @ETRADE, for useful trading and investing insights.