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Treasure Chest: BHP Option Strategy

Treasure Chest | Nov 23 2011

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By Stuart McClure and Michael Jeffery

BHP Billiton Limited – Long dated Bull Call Spread

With BHP Billiton ((BHP)) posting a yearly attributable profit of $21.7 billion in August, as well as the clarity provided by the chairman’s recent address, the company looks poised to capitalise on the increasing demand for its products. Highly leveraged to commodity prices and the underlying growth of China and India, the company looks fundamentally cheap at current levels. If one were to be bullish on the stock and would like to profit from an increase in the BHP Share price a Bull Call Spread may be a suitable strategy.

Strategy Outline

A Bull Call Spread, as the name suggests, is a moderately bullish strategy used to profit from an increase in the underlying securities share price. A bull call spread is slightly less bullish than buying calls outright and is used when the timeframe for the increase in share price is unknown. The advantage of a bull call spread over a bought call is the sold calls offset a large portion of the time decay in the long leg and initially reduce the cost of entry.

Assuming the Current share price of $35.02 a trade could be placed as follows:

Buy June $40.00 calls
Sell June $42.00 calls
Cost: $0.52
Max Profit: $1.48

The initial cost to enter the trade is the maximum risk; there is no margin position on this trade.

Example

100 contracts Trade Size.

Initial Debit 52 cents per Contract (100 Shares Per Contract) x 100 contracts = $5,200 Capital outlay + Brokerage and ACH Fees.

Profit Potential $2 spread ($42.00-$40.00) less the initial Debit paid to establish the position.
Maximum profit = 200 cents x 100 Contracts = $20,000 less $5,200 outlay.
Maximum profit = $20,000 – ($5,200 + Brokerage and ACH Fees).

This trade is a longer term trade noting the options are of JUNE 2012 expiration. The methodology behind selling the higher strike call is to reduce the overall cost base of the trade. The trade is still a debit as the premiums needed to fund the long call are not entirely covered by the premiums received from the sold call at the higher strike.

In summary the trade has the potential to generate 2 dollars per spread less the initial debit paid to open the position.

To achieve a similar return with stock an investor would need to purchase $100,000 worth of BHP shares and see them rally 14.8%. However the investor would be exposed to all of the downside potential in the BHP share price. With the bull call spread the investor is risking a fixed $5200 or 5.2% of an equivalent $100,000 investment, regardless of share price movements.

The following chart represents a pay-off diagram of the above strategy. The x-axis represents the BHP share price in dollars and the y-axis represents the profit/loss per 100 contracts in dollars. Please note that this is a pay-out at expiry and that ASX options positions can exited or altered at any time before expiry. Investors are not "locked in".


Produced by Stuart McClure and Michael Jeffery from Austock Securities. For a free strategy guide on Bull Call spreads or to join the Austock Securities option recommendation mailing list, email invest@austock.com.au or call 1300 331 098 (Qld) or 1300 392 771 (NSW) To learn more about Austock visit www.austock.com.au.. Content included in this article is not by association necessarily the view of FNArena (see our disclaimer).

 GENERAL ADVICE WARNING

The information in this email has been prepared without taking account any one person’s objectives, financial situation or needs. Because of that you should, before taking any action to acquire any of the financial products mentioned on this website or to transfer your personal business to Austock, consider whether that is appropriate having regard to your own objectives, financial situation and needs.

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