On February 24, we published a Tear Sheet suggesting what we call a “bearish diagonal” investment strategy using options on Union Pacific UNP. This strategy used two option legs – a “bearish call spread” paired with the purchase of a long-tenor Out-of-the-Money put option.
The call spread, consisting of a June 2017 call option sold at a strike price of $105 per share and a June 2017 call option purchased at a strike price of $125 per share generated a credit of $5.40 per share, implying an Effective Sell Price (ESP) of ($105.00 + $5.40 =) $110.40 per share.
This option expiration price will be determined by tomorrow’s closing price. If the stock settles below the ESP, your gain on this leg of the diagonal will just be the difference between the stock price and the ESP. If the stock settles above the ESP, your loss on the position will be the difference between the ESP and the stock price. For example, today’s closing price of $110.66 means a loss of ($110.66 – $110.40 =) $0.26 per share ($26.00 per contract).
Barring an enormous drop, the stock will likely settle above the strike price of $105.00. In the case that it does, most brokers will settle the difference in cash. For instance, if the shares close at $110.66, the broker will remove the $5.40 of premium from your escrow account and deduct an additional $0.26 from your cash balance.
I am never happy when a short-tenor position ends in a loss, and am of course, never happy when I recommend a position that ends in a loss. That said, for short-tenor options, random stock price movement is as likely to generate a loss as it is to generate a gain, so I like to keep that perspective.
In the Guided Tear Sheet on Union Pacific, I talk about portfolio management of this position in the case of a loss, so I invite members to review that lesson and review how to “chain together” short-term positions to take a long-term view on a company.
After recommending an investment, I always wait a few days before putting my own order in so that I don’t “front run” any of you. Half the time, this works in my favor. In this case, the stock price moved up a few dollars in the days after I published the original Tear Sheet, so I sold the call option struck at $110. The higher strike price helps me in term of this leg (i.e., I will get to realize more of the premium received), but because I received less on the call spread, I was able to defer less of my cost on the long-tenor put option.
I will publish another Tear Sheet on Monday recommending another short-tenor bearish call spread. Nothing has changed about my investment thesis and my operational forecasts still appear more than generous. Over the longer term, I am confident that the market will function as an accurate “weighing machine” as Benjamin Graham once said.
If you have questions or concerns about this strategy, please feel free to bring them to Office Hours!