Options Trade of the Day: A Baidu Inc. Ratio Call Spread Options traders pile into calls on this Chinese search engine by Joseph Hargett (jhargett@sir-inc.com) 12/16/2010 3:45 PM Text Size | Email a friend | Print | Share Keywords: BIDUstocksoptionseducation Baidu Inc. (BIDU) is quite popular among call traders today, with volume swelling to more than 37,000 contracts. Compared to the stock's average daily call volume of just 14,806 contracts, today's activity is more than 2.5 times the norm. BIDU has plunged beneath the $100 level in the wake of its outlook for a slower growth rate in 2011, and bullish options traders may be looking for the shares to rebound from oversold conditions. The most popular option on the day has been the December 100 call, which has attracted more than 12,000 contracts. However, activity at the January 2011 98 and 107 strikes reveals a much more interesting trading idea. Specifically, a block of 900 January 2011 107 calls traded at about 10:15 a.m. Eastern time on the International Securities Exchange (ISE) for the bid price of $2.54, or $254 per contract. This block was marked "spread." The other leg of this spread centered on the January 2011 98 call, where 450 contracts traded for the ask price of $6.20, or $620 per contract. Given this data, we could be looking at the initiation of a vertical ratio call spread, or a debit spread, on Baidu Inc. The Anatomy of an Baidu Inc. Vertical Ratio Call Spread Breaking down this vertical ratio spread, the trader would have purchased 450 January 2011 98 calls for a total outlay of $279,000 -- (6.20 * 100) * 450 = $279,000. Entering this leg alone, the trader would need BIDU to rally about 5.5%, to $104.20, from today's trading range near $98.75 per share, in order for the position to reach breakeven at expiration. As always, the maximum loss on a purchased call is limited to the initial investment, which is $279,000 in this case. However, the trader has chosen to offset the cost of buying the January 2011 98 call by entering the second leg of this spread. Specifically, the trader sold 900 January 2011 107 calls for a total credit of $228,600 -- (2.54 * 100) * 900 = $228,600. Combining this leg of the trade with the purchased January 2011 98 call results in a net debit of $50,400 -- $279,000 - $228,600 = $50,400. Furthermore, instead of needing BIDU to rally 5.5% in order to reach breakeven, the trader now needs the stock to advance only 3.7%, to $101.66. The maximum profit on this vertical ratio call spread is achieved when the underlying stock rallies to the sold strike, which would be the 107 level in this case. However, since twice as many January 2011 107 calls were sold, this spread position will begin to lose money after BIDU moves above $107 per share. Once BIDU breaches this region, only half of the 900 sold January 2011 107 calls are hedged by the 450 purchased January 2011 98 calls. As such, the trader will begin to lose money on the unhedged portion of those sold January 2011 107 calls as BIDU moves higher. Below is a chart for a rough visual representation of the trade's profit/loss scenario: Implied Volatility While ordinary vertical call spreads are not greatly impacted by rising implied volatility, a spike in implieds could be detrimental to a ratio spread. Since the trader has sold twice as many contracts than he has purchased, rising implied volatility on these options would negatively impact the position, as it would make it more costly to repurchase these contracts should the trader need to do so. At the time of the trade, implieds for the January 2011 98 calls arrived at 43.92%, while the implied volatility for the January 2011 107 call rested at 42.38%. BIDU's one-month historical volatility arrived at 36.71% as of the close of trading on Wednesday.
