A Ratio Vertical Put Spread on Coca-Cola (KO)

Employing the Zacks Unusually High Option Volume screener for today's column, blue-chip carbonation king The Coca-Cola Company (KO - Analyst Report) caught my eye.

According to the Zacks screener, put traders pummeled KO on Thursday, with 14,845 contracts crossing the tape. The single-session volume was almost three times the norm, as the stock typically sees daily put volume of around 5,500 contracts. However, the bearish bombardment wasn't the only thing that caught my eye about Thursday's volume...

During expiration weeks – and even more during triple-witching weeks – it's not uncommon for stocks to see unusually high option volume. With June-dated options expiring after the closing bell Friday, most of the equities on the Zacks filter appeared because of expiration-related activity. In other words, the most actively-traded options were in the June series.

For instance, Research In Motion Limited (RIMM - Analyst Report), General Electric (GE - Analyst Report), E-Trade Financial (ETFC - Snapshot Report), UnitedHealth Group (UNH - Snapshot Report) and a plethora of other stocks all appeared on the same Zacks screener with KO. Nevertheless, the most popular option for each of those securities was slated to expire Friday night, meaning most of the option activity likely consisted of traders rolling out or closing positions.

On the other hand, KO caught my eye because the most popular option Thursday was in the back-month series. More specifically, the soda sultan's August 42.50 put garnered the most attention Thursday, with roughly 7,845 contracts changing hands.

But wait – there's more!

At 10:03 a.m. Eastern time, several blocks totaling 4,500 August 42.50 puts changed hands for $0.40 – closer to the bid price at the time, implying they were likely sold. At the same time, several blocks totaling 1,500 August 47.50 puts crossed the tape for the ask price of $1.65, suggesting they were bought. With that in mind, it appears that we may have uncovered a ratio vertical put spread on KO.

The ratio vertical put spread consists of buying an at-the-money or slightly out-of-the-money put on a stock, while simultaneously selling two or more (where your "ratio" comes in) deeper out-of-the-money puts with the same expiration date. This is a slightly bearish strategy, as the objective is for the underlying shares to close at the sold put strike at options expiration. In this case, the spread trader is expecting the shares of KO to fall to the $42.50 level by expiration on Friday, Aug 21.

The trader paid a total of $247,500 to buy the August 47.50 puts ($1.65 x 100 shares x 1,500 contracts). At the same time, he or she received a total of $180,000 for selling the August 42.50 puts ($0.40 x 100 shares x 4,500 contracts). As a result, the investor incurred a net debit of $67,500 on the position (less any brokerage or margin fees). This is the most the investor can lose if KO stays above the $42.50 level.

Since the spread was established for a net debit, the potential profit is limited to the difference between the two strikes (47.50 – 42.50 = 5), minus the net debit paid ([$1.65 x 1] x [$0.40 x 3] = $0.45). In other words, the most the spread trader can hope to make on this play is $4.55 (5 – 0.45).

On that same note, there are two breakeven points for this position. The first is the sold put strike minus the maximum profit potential, or $37.95 (42.50 – 4.55). The second is calculated by subtracting the net debit paid from the bought put strike, or $47.05 (47.50 - $0.45). Simply put, in order to avoid a loss, the investor needs the shares of KO to fall between $37.95 and $47.05 at August options expiration.

At last check, the stock was drifting in the $49 - $50 region. However, the security could, in fact, succumb to selling pressure should the $50 neighborhood smack it lower again. This level – which acted as support from mid-2007 to mid-2008 – hasn't been breached on a monthly closing basis in quite some time. Plus, the equity's 20-month moving average is descending into the $50 neighborhood, and could act as a second layer of resistance.

In addition, Coca-Cola recently announced that it will release its second-quarter earnings figures before the market opens on Jul 21. A miss in the earnings confessional could help the ratio spread trader in his or her quest for a decline on the charts.

In conclusion, this strategy is best suited for option players with a reputation for accuracy and a high tolerance for risk. In order to profit from this position, the trader must accurately predict where the underlying stock is going to land at expiration. A breach of this narrow range could mean a nasty bruise to your portfolio.