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An alternative, instead of paying
$21.47 for 500 shares - you could go in and purchase options on Yahoo stock. If you purchase
options on Yahoo stock, they do expire at a certain date in the future. You would have
to select the date in which you would like to have your options. You have the July, you
have August, you have October, you have January of 09, and you have January of 10. Those are
the ones that are available right now.
The problem is your timing. You can't really determine when - if, in fact, Yahoo stock
is going to be bought out. Let's say you're relatively optimistic, and you go for the
August options. The August options right now, at the $20 level, are selling for $2.87. The
$22.50 level, the calls are selling for $1.65. At the $25 level, it's 89 cents.
You figure, "Hey, look. If it goes to $30, I buy the $25s for 89 cents." A couple of
these... If I was going to buy 500 shares of stock, I can buy 5 of these calls, and
basically limit my risk and also have some good upside potential. If it goes up to $30,
these $25 calls in August are going to be worth $5, because they're $5 in the money.
The only problem is, of course, you have to be right as far as your timing. The deal has
to come in before the 3rd week of August, in order for these $25 strike calls to be
worth anything at all. If this goes to $26, you're just about breaking even. If the buyout
price is $26, those August calls are going to be worth $1. That's going to be your breakeven
point right there, after commissions.
If you buy the $27.50 call, those are only 48 cents. The problem is, if the takeout price
is $30, you only have $2.50. That's still not bad, because you're going four times the
price of what you're buying here, maybe even five times the price. That's a good-sized
profit.
Let's take a look at the 25s, because you want to get that full $5 of profit potential
in there. Let's take a look at it and analyze it, just like we did with the stock. You can
tell that yes, you do have unlimited upside potential here. If the stock moves up to $30,
you could make $2400 on 5 contracts of the August 25 calls.
You also could lose your entire investment if the stock doesn't move. In fact, if the
stock doesn't move within 2 or 3 points here, you're going to lose your entire investment,
which is - I agree, it's not much. It's only $445. Still, you don't want to do this 2 or
3 times a month. You don't want to do an investment, and just buy outright calls, especially out
of the money calls on these kinds of stocks. If nothing happens, you end up losing about
$500.
In order for this to break even - you can see that the breakeven price here is just
a little bit over $25. In order for this to work out, you have to be above $25 to make
any money. Anything below, or anything above that, up to $25.25, you're going to lose almost
the entire investment, of $445.
It's not a bad play, but I think we can do better. Let's go back and take a look at our
Trade tab, for a second. The other thing that you could possibly do is create a vertical
spread. In other words, you want to buy a lower-priced strike-price call, and you want
to sell a higher strike call.
This creates a spread which limits your risk to the downside. If you are wrong, the call
that you sold will reduce in price, generating a small profit. This helps you reduce the
risk on the long call that you purchased.
Let's say you're really bullish. You really think this deal is going to work out. You
go for the $22.50 call, and you sell the $30. You sell the one that you think is going to
reach where the price is going to be, if somebody does make a takeout offer. So, let's say they
offer $30 a share for Yahoo.
That's what you want to sell, if that's what your analysis is telling you. If you think
it's going to be $35, you could go up to $35. The problem is that these are so low-priced
that selling these calls up here doesn't really give you much protection on the downside,
does it? So I don't recommend that.
This is a potential strategy. You go to "Buy a vertical spread," and the spread we want
to sell is the $22.50 $30. We want to sell those $30 strike price calls there. That's
going to cost us $1.43 at the mid-price. We'll probably get filled at around $1.45 for that.
It has the potential of moving up $7.50, if we do hit our price target.
Now, we want to do this 5 times. We're going to go ahead and analyze this as a duplicate
trade. Let's see what happens. Well, right now, with the price right in here at $21.51,
which is right here on my graph - what you can see is that you still have to move up
in price, in order for this thing to work. This is expected.
You really do think it's going to hit $30. If you hit $30, your potential payoff is around
3000. That's a pretty good payoff, no doubt about it. If it works out and somebody does
offer $30 a share for Yahoo, you're going to make about $3000, because you'll be right
in here.
The problem is, of course, is if nothing works out at all, or the stock goes up a little
bit - you're going to potentially lose the maximum amount of money. In this case, it's
$725. If the deal does not work out, the stock trades down to $15, or even if it just stays
the same - if it goes from $22 or $23 - let me just spread this out a little bit... If
it doesn't trade that high, if it stays below that, you will have lost almost the entire
investment of $725.
That's even worse than buying the outright call. The outright call only cost you $445.
Vertical spreads can be good in these situations. However, you're still risking a maximum loss
of $725, which is the cost of your spread.
Is there an alternative? We looked at buying the stock. We looked at vertical bull call
spreads. Now, we've also looked at outright buying a call, to take advantage of any upside
potential. The problem, of course, is that you have large downside risk, if the deal
doesn't work out.
Let's go back to our chart for a second. If the deal does not work out, and it trades
down to $18.50 or below, you're going to lose all of your investment. You're going to lose
a lot of the investment in your stock. You're going to lose most of the investment in your
call. If you're lucky, you get out before the bad news hits, and you saved a little
bit of your call premium. Or you put on a vertical spread, a bull call vertical spread
like I mentioned. That's going to cost you $725, and there's no guarantee that it's going
to move up enough for you to get into any kind of a profit situation at all.
None of these scenarios are really interesting for me. What I like to do is introduce you
to the concept. I'm going to show you a portfolio of these trades. This trade, in particular,
was shown to me by a 30-year veteran in the markets. One gentleman who had run a brokerage
firm in New York City for many years had retired, and this is a strategy that he developed.
He was going to retire, but he ended up not retiring. Instead, he started a small hedge
fund that only does these kinds of trades.
This is really inside information that you're not going to find anywhere else. It's very
similar to another kind of trade that's talked about a little bit in several different books,
but it has a couple of different twists to it, that I think you're really going to find
interesting. If you know options at all, you know what a back ratio spread is.
This is very similar to a back ratio spread. The difference is that it's much more favorable
to the person putting it on with very limited downside risk, maybe even a profit on the
downside, and unlimited upside risk, which you don't really get with a back ratio spread,
very often.