As earnings season winds down and investors are digesting the last few reports, implied volatility in options contracts gives us an idea about which stocks are expected to move most after they report. Right now, traders are expecting a big move in Lululemon Athletica (LULU - Free Report) .
In the weekly options that expire on Friday June 1st, the 105 strike straddle is priced at about $8.50. Because those options expire the day after earnings and there’s not any additional time for other news in LULU or general sentiment to move the stock, that means the market expects a move of about $8.50 as a result of the report.
In the past 10 quarters, LULU has moved an average of $7.07 on the day after an earnings report, though in each of those instances, the stock was trading at a lower level than today, so in percentage terms the expected move is not too far out of line with recent experiences - simply a little bit high.
There is a limited-risk trade you can execute that will profit handsomely if the earnings report fails to move the share price. It’s called an “Iron Butterfly.”
(Prices used are the midpoints of the bid/ask at the end of the day Wednesday.)
Buy 1 100 put @ $1.90
Sell 1 105 put @ $4.00
Sell 1 105 call @ $4.60
Buy 1 110 call @ $2.20
Total credit on the trade: $4.50
You’ll notice that this trade looks like a combination of two simple spreads. You can think of it either as selling the at-the-money straddle and buying an out-of-the-money strangle, or as selling a put vertical spread and selling a call vertical spread. Both are technically correct.
When the options expire on Friday afternoon, there are a few possible outcomes for this trade. One is that the shares are trading below $100 or above $110. In this case, you would be short one in-the money option and long one in the money option with a $5 difference between the strike prices, resulting in a loss of $5 minus the $4.50 you collected on the opening trade for a net loss of $0.50, or $50 for each iron butterfly sold. This is the maximum loss on the trade (plus commissions and fees).
If the stock is inside the range between $100.50 and $109.50, the trade is profitable. The closer the stock is to $105, the higher the profit.
If the stock is trading at exactly $105 at the close on Friday, all the options would expire worthless and you would keep the entire premium collected - $4.50, or $450 per spread. This is the maximum profit possible.
Obviously, shares do tend to move after earnings announcements, so there’s a reasonable chance of losing the entire maximum amount, but if the announcement is a dud, the payoff could be as high as 9 to 1 – pretty good odds.
A Note on Execution at Expiration
Because this spread involves being short at-the-money options, there’s a possibility that you will have to close one leg before the options expire.
If the stock is lower than $100 at expiration, both puts will be automatically exercised and no further action is required. You’ll buy the stock at $105 and sell it at $100.
If the stock is above $110, the same is true of both calls. You'll sell the stock at $105 and buy it for $110.
If, however, the stock is between $100 and $110, you’ll need to either buy back one of the short options or enter into an offsetting trade in the stock in order to have no position after Friday.
If the stock were trading at $103 just prior to the close on Friday, you could either buy back the 105 put for something close to it’s intrinsic value of $2, or you could sell 100 shares of stock at $103 (which you will buy back for $105 when the short put is assigned against you), locking in a $200 loss on the stock trades while keeping the original $450, for a net profit of $250.
If the stock is trading $107, you could either buy back the 105 call (again for something very close to its $2 of intrinsic value) or you could buy 100 shares of stock at $107, locking in the same $250.
In the unlikely, but not totally impossible event that the stock is trading at exactly $105 (or within a few cents), it’s probably wise to buy back both options for as little as possible to avoid acquiring a position in the stock that you’re not interested in holding. Since this price will have resulted in the maximum possible profit on the trade, spending $0.10 - $0.20 of that profit to close the short options and eliminate any chance of acquiring a stock position is inexpensive peace of mind.
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