Spread Strategists Go Lightly on Tiffany (TIF)

Employing the Zacks Unusually High Option Volume screener, high-end jeweler Tiffany & Co. (TIF - Analyst Report) caught my eye.

Put Mania in Manhattan

According to the Zacks screener, TIF was a favorite target among put traders on Thursday. More specifically, the security saw almost 20,000 puts cross the tape, nearly 7 times its average daily volume of fewer than 3,100 contracts. Most active was the stock's Jun 22 put, which saw roughly 12,250 contracts change hands. However, after digging deeper into the data, it appears that the majority of that volume crossed at the respective bid prices, suggesting they were sold.

At 2:52 p.m. Eastern, several blocks totaling 12,000 Jun 22 put contracts crossed the tape at the bid price of $0.85. Since all were marked "spread", I searched for similar activity from other options at around the same time. After further research, I found complementary activity surrounding the TIF Jun 25 put, which saw several blocks totaling 6,000 contracts change hands near the ask price of $1.95, suggesting they were bought.

Simply put, it appears that a savvy options player may have initiated a ratio spread with puts on TIF.

A Posh Put Spread

To initiate this strategy, a slightly bearish investor would buy a near-the-money put, and simultaneously sell two puts at a lower strike but with the same expiration. The strategy allows the trader to obtain the higher-strike put at a discount, as the premium paid is partially offset by the premium received from selling the lower-strike puts – resulting in a credit or small debit. Ideally, the spread strategist wants the underlying equity to end at the lower strike at options expiration.

Breaking down the math for the aforementioned put-spread strategy, the trader – let's call her Holly, just for giggles – received $1.02 million for the 12,000 sold Jun 22 puts (premium of $0.85 x 100 shares x 12,000 contracts). On the flip side, Holly paid a premium of $1.17 million to purchase the 6,000 Jun 25 puts (premium of $1.95 x 100 shares x 6,000 contracts). When all was said and done, Holly incurred a net debit of $150,000 ($1.17 million - $1.02 million).

In this case, Holly's ultimate goal is for the shares of TIF to end at the 22 level by options expiration on Friday, Jun 19. Her maximum potential profit is limited to $1.50, or $150,000, which is the difference between the strikes (25 – 22 = 3), minus the net debit paid ($1.50). If she would have established a net credit, her maximum potential profit would have been limited to the difference between the strikes, plus the net credit received.

There are two breakeven points for this trade: 20.50, which is the strike of the sold puts less the maximum profit potential (22 – 1.50 = 22.50), and 23.50, which is the strike of the purchased puts less the net debit paid (25 – 1.50 = 23.50). In other words, shares of TIF can finish between 20.50 and 23.50 before Holly incurs a loss.

Meanwhile, if the stock rallies past the 23.50 level by June options expiration, Holly's maximum potential loss on the position is limited to $150,000, which is the net debit paid. On the other hand, no matter how far TIF should fall before options expire, the most she can lose is $23.50, or $235,000, which is the strike of the sold put plus the net debit paid (22 + 1.50 = 23.50).

In Conclusion...

At last check, shares of TIF were flirting with the 25.50 level, a gain of 10 cents, or 0.4%, from yesterday's close. In order for Holly to capitalize on her strategy, the stock would need to backpedal about 12% from its current spot on the charts.

What Holly has in her favor is time decay, which is eating away at the value of her 6,000 bought Jun 25 puts, but is also decreasing the value of her 12,000 sold Jun 22 puts. The maximum value of ratio spreads with puts is typically achieved closer to options expiration. What she must keep an eye on is the implied volatility of these two positions. Rising implied volatility is negative for her sold positions, and will overshadow any increase in the implied volatility of her purchased puts.

Finally, before embarking on your own ratio-spread strategy, remember that although one of the puts you sold is covered with a bought put, your second sold put is still "uncovered," and can leave you vulnerable to significant downside risk. In addition, investors will want to have stop-loss levels in place before initiating this strategy; if the stock falls too low, your portfolio could go from Fifth Avenue to Rikers Island.

Read the full analyst report on TIF