When traders are debating about how to capture profits on a stock they think will continue to move higher, they have several choices. One way is to simply buy the stock — if the stock moves higher, the trader profits. However, traders also can buy call options that can profit if the stock rises, offering limited risk.
Here is a trade idea that’s something of a combination of the two.
Boyd Gaming (NYSE:BYD — $8.85): Diagonal Spread
The trade: Buy the January 2015 10 calls and simultaneously sell the May 11 calls for a net debit of $1.80 or better.
The strategy: A diagonal spread involves buying one option and selling another option with a different strike and different expiration month. It is essentially a time spread. The goal in this instance is for the stock to trend slowly up and eventually help pay for the long-term call with the short-term call’s premium received. It is somewhat similar to a covered call, but instead of owning the stock, a long-term call is purchased instead. A perfect-case scenario is for the stock to be slowly moving higher and be trading right at the short call’s strike at expiration. The most that can be lost is what was paid for the spread.
Click to Enlarge The rationale: Boyd Gaming is one of the biggest casino entertainment companies in the United States. It owns or operates 22 gaming properties in eight states.
BYD shares surged higher on Thursday after Morgan Stanley upgraded the stock. MS believes that with New Jersey approving online gambling in February, similar green lights are likely to pop up across the country, and the gaming sector is poised to take off in the next few years — and Boyd stands a good chance of capitalizing the most based on its fundamentals.
Morgan Stanley has a target price of $12 on Boyd, though that doesn’t mean the stock can’t move higher than that — especially if you look at a 10-year chart.
The problem: How does a trader capture a potential move higher over the long haul with limited risk?
One way is with a diagonal spread. A trader can buy a call option (in this case the 10 strike), which gives the trader the right to buy the stock at a certain price before a certain time with an expiration of over 640 days. This will give the stock a good amount of time to move higher and increase the premium on the call option. To lower the cost of the trade, a trader can sell a call option each month with the same or higher strike (in this case the 11 strike) to offset the long calls cost.
The goal is to have the stock trading right at the short strike at expiration, and the short call would expire worthless. This process can be duplicated if desired each month to continually help decrease the cost and simultaneously increasing the long calls’ intrinsic value. If the stock moves higher, the trader can keep selling a higher-strike call every expiration.
As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.