Market Insights

Two weeks ago, a options traders were bullish in a slot-machine maker. Yesterday, a similar transaction lit up a race-track and casino operator.

Traders bought 6,000 June 31 calls in Penn National Gaming (PENN) for $1.25 in the middle of the afternoon. A block of 12,000 June 34 calls was sold at the same second for $0.35.

Owning calls fix the price where a stock can be purchased, so they make money to the upside. Selling them forces investors to deliver shares if a certain level is reached. Many readers probably know the two can be combined into a vertical spread. (See our Knowledge Center for more.)

Monday’s trader went a step further by selling twice as many calls to form a “ratio” spread. It’s is risky strategy if done in isolation because they’re effectively naked short calls. But there’s a good chance yesterday’s traders were holding at least 600,000 PENN shares and used the ratio spread to juice their gains. Here’s how it might work out:

• They paid a net $0.55 for the 6,000 contracts they own at the $31 strike. (6,000 contracts X $1.25 ) – (12,000 X $0.35) = $0.55.
• If PENN closes at $34 on expiration and the options are exercised, the trader can collect $2.45 per contract — a potential profit of 445 percent.
• Above $34 their gains diminish money because they’re short calls. But if they hold stock, they could simply deliver shares. (Similar to a covered call.)
• If PENN closes at or above $34, the short-call position will expire worthless. Above that level, profits diminish and risk increases. However if the investor is holding stock, he or she could simply deliver shares for $34. (Similar to a covered call.) The success of this part of the trade would be determined by the stock-purchase cost.

PENN ended the session up 1.17 percent to $30.31. It gapped higher on April 26 after beating estimates and raising guidance. Management credited the gains to improved operations at its facilities across the U.S. and synergies after the purchase of Pinnacle Entertainment (PNK) last year.

Almost 29,000 contracts traded in PENN yesterday, its busiest session in at least four years. Calls outnumbered puts by a bullish 143-to-1 ratio.

Penn National Gaming (PENN)