Hey Traders,
We’ve been talking a lot about spreads lately …
And there’s a reason for that.
By now, you should already know that most spreads are simply simple calls and puts strung together in ways that help you achieve trading objectives like capping your risk, lowering your costs, or even targeting gains on specific options pricing factors like volatility and time decay.
Big Money traders use spreads all the time to make massive plays.
Now, Big Money often has different trading objectives, versus us as retail traders.
So not all Big Money trading strategies are suitable for people like you and I.
For example, trading delta neutral often requires quite a large outlay, and very active management that just isn’t practical for most people.
But Smart Money traders frequently use simple trading strategies that are exactly like trades we would make … just a little bigger.
Let’s look at an example.
This trade we’re about to look at is about the simplest spread trade you can make.
We talked about these just a few weeks ago, so if you want to take a little bit of a deeper dive, you can do that right here.
And if you decide you want to give some of these more “complex” trades a try, I’m debuting a new service – Nitro Trader – where my goal is to help you make the same kinds of trades that I’ve been using to profit in my hedge fund for YEARS.
The fact that you can really control your risk and reduce your trade costs makes these trades IDEAL for trading in a volatile environment like the one we’re in now.
But let’s look at this Smart Money trade that crossed the tape earlier this week …
Tech stock Dynatrace (Ticker: DT) has been struggling since hitting an October peak of $80.13. A poorly-received earnings report saw the shares gap lower, and though they briefly closed that gap, the shares have been under steady pressure ever since.
Chart courtesy StockCharts
Earlier this month, DT issued disappointing guidance, which saw the shares plunge 18% in a single trading session, and they seem to be continuing their trend lower …
DT closed on Wednesday at just $41.09, nearly 49% off its peak just four months ago.
And yet … Big Money seems to think DT will be able to turn this trend around …
On Tuesday, we saw a rather large call spread opened up in DT’s pits …
This trader opened up 6,141 contracts of the May 45/55-strike call spread, buying the 45-strike calls for $3.40, and selling the 55-strikes for $1.10.
This would put DT back into the range where it was trading pre-February-plunge.
Let’s take a look at this spread, and think about why Big Money chose to express their opinion as a call spread.
Instead of spreading, Big Money could have purchased calls outright. After all, that would give them unlimited upside potential, rather than capping their gains once DT reaches the 55-strike.
However, a straight 45-strike call purchase would have cost this trader $2,087,940. If these calls expire worthless … well, Big Money’s down quite a large chunk of change.
However, by selling the 55-strike calls, they were able to reduce the cost of their trade by $675,500, so they’re only paying $1,412,430 to capitalize on DT upside.
Yes, that’s still a lot of cash, but $675k saved is nothing to sniff at, especially when you consider they’ve also reduced their maximum loss.
Another way to think of it is by looking at the breakeven price of the trade.
If this trader had purchased the 45-strike calls outright, their breakeven price would have been $48.40.
By reducing the cost of the trade, they also moved their breakeven price down to $47.30 – so they’ll start profiting $1.10 sooner than if they had bought the calls outright.
However, like I mentioned, selling the 55-strike calls does reduce this trader’s maximum profit.
Rather than the unlimited profit potential of buying calls outright – or buying shares – this trader has capped their profit at $7.70 per contract ($10 difference between strikes, less the $2.30 premium spent).
But that does come out to a nice $4,728,570 … so it isn’t like they’d be walking away with nothing if DT suddenly shoots to the moon!
It’s also interesting to note that following DT’s October gap lower, the shares did indeed move up to fill the gap in the weeks following before resuming their downtrend.
If that pattern appears again, it would mean a DT recovery is capped right around … $55.
Chart courtesy StockCharts
And of course, buying the shares outright would be very, very expensive.
These 6,141 call spreads represent 614,100 shares of DT stock. Purchasing that number of shares would cost $25,233,369. Not only is that an impractically large outlay – even for many Big Money traders – but that also opens them up to huge risk should DT take a sudden plunge…
Which isn’t exactly unheard of!
So you see …
By simply executing one other trade (selling the calls) this trader is capping their risk and lowering the cost of their trade, while still being set up to reap quite a nice benefit if DT can get its act together by May.
Call spreads work the same way for YOU … we’re just not shelling out millions of dollars at a time when we place our trades!
If you’re ready to start making trades like this … Nitro Trader is the place for you.
Your Only Option,
Mark Sebastian