Spreading your options
04/27/18

This week a stock returned to a conspicuous price level for the third time this year, and at least the fifth time in the past year or so. Yet the way active trading goes, one group of traders is likely to see one type of opportunity, while others are likely to see just the opposite.

The stock in question is semiconductor company Broadcom (AVGO), which on Wednesday bottomed at $225.86, very near its April 2 and February 6 swing lows—as well as the July 2017 low and the March 2017 high. Really, how obvious can a stock get?

Broadcom (AVGO), 11/29/16 – 4/26/18

Source: OptionsHouse

What’s not obvious is whether AVGO’s latest test of support suggests the stock is finally going to break below this threshold or whether it’s going to stage yet another bounce (yesterday was a narrow-range inside day that closed higher).

But let’s say a bullish trader was inclined to trade the long side based on:

●An up-and-down broader market (and tech sector) that appeared to be rebounding off a swing low.

●Broadcom’s history of strong performance, including positive earnings surprises in at least the past four quarters.1 (The stock’s average analyst price target is above $300.2)

●The stock’s history of rebounding off this support level.

One possible approach would be to simply buy the stock and place a stop order somewhere below the support level—ideally at a price that recognizes the possibility (some traders would say “the likelihood”) that the stock could penetrate the support level by a significant margin, at least on an intraday basis, before turning higher.

Options may offer the ability to take advantage of expected upside while limiting downside exposure—but without the risk of a hard stop-out on a stock position. One possibility would be a bull call spread: a long at-the-money call option and a short out-of-the-money call option with the same expiration. The short call offsets the cost of the long call, and offers downside protection in the event the stock continues to drop.

But there’s also a couple of reasons a trader would instead use short put options—either selling out-of-the-money puts (say, with a strike price below the support level), or creating a put spread with short and long puts. First, the stock’s recent downswing boosted the value of puts relative to calls. Also, yesterday AVGO options implied volatility (IV) was around 34%, which was toward the upper end of its 52-week range of 13%-41%. Higher IV means higher options premiums overall, which means a short-put strategy could allow you to sell something with a relatively inflated value. 

Options spread profit/loss profile. AVGO vertical put spread P/L

Source: OptionsHouse

The chart above shows the profit/loss profile for a representative put spread: selling a May $230 put (roughly at-the-money based on yesterday’s prices) for 7.00 and buying a May $220 put for 3.50, for a 3.5 ($350) net credit per spread, which is also the maximum profit; the maximum loss is $650.

Yes, the long put cuts into the premium you’d collect by simply shorting puts, but it also caps your losses if the stock continues to decline below $220. Also, if the stock price does briefly dip below that level before rallying, your position has a good chance of remaining intact (that is, you won’t automatically get assigned stock on your short put), whereas if you were long stock and used a $220 stop-loss, you’d be knocked out of the trade.

The combination of a modest (capped) profit and a slightly larger maximum loss might not appeal to everyone, but when market direction is uncertain, and price swings can be quick and unforgiving, a little extra wiggle room can be a good thing.

 

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.


1 Nasdaq.com. Broadcom Inc. Earnings Surprise. 4/26/18.

2 E*TRADE.com. Broadcom Analyst Price Targets. 4/26/18.