Sunday, June 27, 2010

EBAY... No Bids?

After breaking down selling put spreads, how about a few thoughts on buying them? Recently EBAY seems to have fallen out of favor as its stock price has experienced notable weakness relative to the tech sector and the overall market. What might be a strategic way of positioning oneself to profit from continued weakness in this online shopping mall? Options Action suggests purchasing an August 21-17 put spread for $1.00. Buying a put spread (also commonly, and perhaps redundantly, referred to as a bear put spread) consists of simultaneously buying a higher strike put while selling a lower strike put in the same month (click image to enlarge).

In the case of the EBAY spread, the best case scenario occurs if it resides beneath $17 by August expiration. The maximum profit for long put vertical spreads is equal to the distance between the strikes ($4 in this case) less the debit paid to enter. Consider the risk graphs below:
[Source: MachTrader]

One question worth considering is whether or not it is advantageous to sell the Aug 17 put which caps the profit potential. Why not just buy the Aug 21 put outright and have unlimited profit potential? The typical rationale for the superiority of the spread is it cheapens the trade while also hedging time and volatility risk. The problem I see with this particular spread on EBAY is the Aug 17 put only reduces the trade by $.25 When entering directional spreads I prefer to have the short option reduce the overall cost by around 1/3. At $.25 or about 1/5 the value of the long Aug 21 put, the Aug 17 put falls just a bit short. Shorting the 18 put is probably more up my alley.

Like most practitioners of technical analysis, I'm a fan of waiting to pull the trigger until after I have some type of catalyst. With EBAY currently sitting at long term technical support around $20.50, I'd prefer to see a breakdown before plunging into this type of play.