Caterpillar Again. An Attempt To Explain The Concept of Creating a "Spread".

Caterpillar just had earnings come out and they were lousy. Read my January 26th blog, That was only only four days ago and it's easy to find. There you will find charts and option quotes which I just updated to complete the story showing how crazy it's price drop was. Holding both both a Call and Put at the same time just prior to the release of it's earning report could have worked out nicely, or better yet, just the purchasing of a Put. Here is a chart of how it sold off in the first fifty five minutes of trading this morning.

It's a respectable drop which made all Put holders very happy. So here is a new question. Is there now an opportunity to play a rebound? Today is January 25th and there are beaten up Call options on it that expire tomorrow. Buying a Call option on it that expires in one day is an extreme risk, especially with all of Trump's meddlings. Now look at the pricing of the "one-day-to-expiring" Caterpillar Call option. Can you see how this series of "one-day-to -expiring' Call options last traded at $4.00? That's four hundred dollars U.S. The actual "bid" and "ask" seem to have a wide spread but that's just how the option makers like to close their trading platforms at the end of the day.

Now that the stock has dropped so much in price some option traders might look at this as being a rebound opportunity. Rather than buying a Call option on it hoping it will go up some traders might consider doing a "Spread". What is a "Spread"? It means making two option trades on the same stock at the same time. If we are thinking of playing it for the upside it means buying a longer term Call option on Caterpillar and selling against it a shorter term Call option on Caterpillar. In the example I am about to show both all options will have the same striking prices but different expiracy dates. What is the purpose of engaging in such an exercise? Well in this case one would be banking on the stock stumbling a little bit tomorrow and hopefully expiring worthless before it takes off again to the upside. That's why it is called a Spread. Does it sound like a convoluted approach to doing things? Well it really isn't. Now look at this.

What are we looking at? It's another Caterpillar Call option with the very same striking price but this time its one week out. It would cost you about $700.00 to buy in. To do a spread one would buy one of these Calls which buys you six more days of trading life for Caterpillar to find its legs and rebound back up. At the same time one would sell against it a Call on Caterpillar with the same striking price but that expires tomorrow. So the next question is, how could this work to your advantage? Well part one of this answer would be to look at how these two different Call options ended up closing out the following day which happens to be the same day the first series of Calls we are looking will expire. Let me show you what happened in this case. Caterpillar traded down in price and the January 31st, 375 series of Calls expired worthless!

That means you just made $400.00. Well $400.00 minus the cost of buying one contract (about $10.00). It also means that you're now left holding a "one-week-out" 375 series of Caterpillar Calls. There is now a catch. Caterpillar came down in price so the option you are now left holding is suddenly also worth a lot less. Look at it's current value at this point in time.

If you paid $700 to buy it and it's now worth about $400.00 you lost on paper $300.00 and at the same time you are up $390.00 on the first contract you purchased expiring worthless, so really you are only up about $90.00. Ii might seem like a lot of work for nothing. It kind of is. Yet then again you could have liquidated your second position in the last minute of trading on Friday making a $90.00 profit. In a sense the stock almost dropped to much. Had it sold off to let's say only the $375.00 level then your "next-week-out" Call option would have been worth a lot more than $400.00. The potential of capitalizing on this windfall helps in part to justify this strategy. Are you confused? I will keep tracking this series of Call options next week to better explain what could have happened. Here is how the Caterpillar five day chart now looks.

Let's watch and see what happens.