For my debut article today, I shall cover a stock that was in play and moved over 12% last Friday. Although not an index component, it is one of the most important bulk carrier operators in the world today. The stock is DryShips Inc. , stock symbol DRYS.
DRYS dropped from its high of $131.34 in November 2007 to its present price of $6.84 due to the world economic crisis. In this crisis, transportation and shipping companies were particularly hard hit from the lower exports and production. In fact, DRYS's profit margin is now a staggering -63.09%.
By the end of last year, DRYS had a total debt of about $2.5 billion but surged over 12% last Friday when it negotiated a big debt waiver in the value of $654 million. This is certainly great news for DRYS.
On the technical front, DRYS has been climbing a gradual uptrend on rising volume, indicating investment interest pouring into the stock steadily. Short term resistance level can be identified at the $11 region, which is about 60% higher.
With these data and a short term trading horizon, we could trade on a reward risk ratio of 3.8 : 1 using what is known as a Bull Call Spread. A bull call spread is when you buy call options on a stock and then short further out of the money call options in order to reduce capital outlay and thus increase reward risk ratio. Since we are expecting a short term gain in the price of DRYS up to about $11, we could put on what is known as a 7.5/11 Bull Call Spread. This means that we buy the $7.50 strike price call options and then Sell to Open as many $11 strike price call options. Since it is a short term move we are expecting, we will not buy options with too far an expiration date but not so near as to not give the stock enough time to move. Generally, about 3 months out would be nice. For this trade, we shall use the September options.
DRYS's Sep 7.5/11 Bull Call Spread is priced at a debit of $0.90 ($0.95 - $1.85) as of Friday close. See how the short call options help reduce the overall debit of the position? If you had merely bought the call options, you would incur a debit price of $1.85 instead. The maximum profit of $3.50 (11 - 7.5) achievable by the position is when DRYS stock price reaches $11 or higher. At $11, the $7.50 strike price call options would be worth $3.50 while the $11 strike price short call option would be worth nothing. The reward risk ratio is 3.50 : 0.9 or 3.8 : 1. What this says is that for every dollar at risk, you could potentially gain $3.80. This ROI would have been much lower if you had merely bought the Sep $7.50 strike call options or the stock itself. Indeed, the primary aim of the Bull Call Spread is to dramatically increase your ROI.
The main drawback of the Bull Call Spread is that you could lose all the money in that trade if DRYS closes below $7.50 upon Sep expiration. You put at risk any money you have in that trade, nothing more. You would not be required to put in more money than that if things don't work out. This is also the beauty of debit spreads like the Bull Call Spread. Since you could lose no more than the money you have in that position, you could size your position to your preferred risk amount! Yes, if you could lose no more than $500 in a single trade, use no more than $500! Its that easy. With $500, you could buy 5 contracts of Sep $7.50 Call options and short 5 contracts of Sep $11 call options. If DRYS reaches $11 by expiration, the position will be worth $1750! See how you can make a dramatically higher ROI with options trading?
Now, could this trade work out as planned?
DRYS has been riding the stock market rally so far and with a beta of 4.56, it could be depended upon to gain more than the market in terms of % if this rally continues. With economic outlook improving dramatically for year end and 2010, the stock market would certainly move ahead of these developments as it has always does. This puts the market in DRYS's favor and the odds in the favor of our DRYS bull call spread.
I will update the status of this Bull Call Spread in my weekly column as well, so, stay tuned!
Please read my tutorial at www.optiontradingpedia.com/free_bull_call_spread.htm for more information on Bull Call Spreads.
Disclaimer : Neither I nor Masters 'O' Equity or Optiontradingpedia.com and any of the staff, own any shares in DRYS nor hold the above mentioned options trading position. The above article uses closing prices on 15 May 2009. Actual prices on Monday opening may differ. This article is for education purpose only and should not be taken as individual investment recommendation. Options trading is not suitable for everyone and advise should be sought from your local financial adviser.