Dillard’s Inc. (DDS) is on a nice uptrend and above all of the key averages. One way to get in on DDS is to play option verticals. If we think DDS will continue to go up we can sell a bull put spread against the stock. A bull put spread is formed by selling one put option and buying one put option below it.
We’re going to target the February options which are 32 days from expiration. Using the Risk Profile in Think or Swim we can click on set slices and set the graph to 1 standard deviation from the current price and set the date for 2/18/11 which is February Expiration. The Risk Profile shows us that 1 standard deviation from the current price is 44.71 and 35.45. We can create a simulated order where we sell the February 35 Put and buy the February 33 Put and collect a premium of $20 per contract. This sets our maximum gain at $20 per contract and $180 is our maximum loss per contract.
The 20/180 risk reward may sound crazy, but when we move over to the Probability Analysis tab and Set Slices to Break Even we see that our break even price is 34.80. In order to make money DDS simply has to stay above 34.80. The probability of it being below 34.80 as of today is 14.23% and above 34.80 is 85.77%. You can adjust the date forward on this tab to see the probability of success go up as we get closer to expiration. That is of course assuming everything remains the same. You can also click the wrench below the date on this tab to change the stock price and volatility to see how that affects the probability of being above 34.80 by February expiration. 86% of being successful is very good odds.
To calculate our return on investment you take the max loss minus the initial credit (180-20=160) and divide that into the initial credit of 20. So we have 20/160=.125, or 12.5%. We have an 86% chance of making 12.5% in approximately 32 days.