Thursday, September 17, 2009

Best Buy Earnings Play Redux

So how'd the Best Buy earnings play highlighted a few days ago work out?

Let's take a look-

The play was a bearish 1x2 put spread where we purchased 1 Sept 37.50 put and sold 2 Sept. 35 puts for a net debit around $.20. To realize the max profit we needed BBY to be at $35 by Friday's expiration. Take a look at the chart below to view BBY's reaction to earnings (click on image to enlarge).

[Source: EduTrader]

Prior to earnings BBY was trading around $40, making the Sept. OTM put options we used rather cheap. Although BBY sold off after earnings, it didn't sell off as much as I would have preferred. Right now BBY is trading around $37.70, making the Sept. 35 puts worthless and the Sept. 37.50 puts trading around $.30. I decided today to close out the long 37.50 put for $.30 and let the 35 puts expire worthless tomorrow. With only one day left to expiration and the 37.50 puts currently OTM, it would be a gamble to hold them tomorrow and risk having BBY remaining above $37.50.

If you entered at a debit of $.20, you'd have a 50% profit. Although $.20 was the net debit used on Friday night, reality is you probably wouldn't have been filled unless you entered around .30 or .35 debit. That being the case, the trade was probably a wash (at least it was for me).

I don't tend to dabble with vertical ratio spreads too often, but based on the BBY trade I think it's fair to say that they provide a better alternative than buying puts or calls outright when making a directional bet going into earnings.

3 comments:

Mark Wolfinger said...

Tyler,

Just my two cents, but it is an alternative perspective.

I don't see how you can consider holding a long put option when it is priced at $0.30 to be gambling, but not consider holding two puts that are OTM by 2.5 points not to be gambling.

I do agree that there is a much higher probability of losing that $0.30 if you don't cash in now, but losses from the naked puts can - every once in awhile - be very costly.

As I said, just my two cents.

Brst regards

Tyler Craig said...

Mark,

As always I appreciate the alternative perspective so thanks for the comment.

My rationale for stating that holding the long 37.50 puts was gambling was as follows:

1. The catalyst for the trade(earnings) had already occurred and the stock had already made a decent sized move in reaction to the event. WIth the catalyst done and over with, no sense in staying in the last day to risk losing the entire investment.
2. With one day left and the long puts sitting mildly OTM, I think it's fair to say it would be a gamble to hold those just based off the hope that BBY drops enough the next day to offset the time decay and allow me to exit at $.30 or better.
3.Although $.30 isn't a high dollar amount, it was the entire cost of the trade. Risking the entire amount of capital placed in the trade based on a lower probability event ( like BBY dropping far enough on Friday) is a gamble IMO.

As to the 35 strike naked puts, I tend to agree with you. I usually do not advocate holding naked short puts just because they are "worthless". I usually close out OTM credit spreads and naked short options when I've made the majority of profit.

Although I don't mean to rationalize away the chance for a catastrophic move down in BBY on Friday, my reasons for assuming the puts would expire were as follows:
1. One day left
2. Options were about 6.6% OTM
3. BBY already reported earnings, so no major catalysts occurring between the Thursday & Friday
4. Market has been uber bullish further diminishing the liklihood of those 35 puts moving ITM on Friday.

In the end whether you call it a gamble or not, to me saving the $.05 plus commission by not buying back the puts was worth taking risk of a catastrophic move drop in BBY.

Mark Wolfinger said...

Of course - that's the bottom line. If it's worth it to you to take the risk - then you take it.

I just don't want to see beginners encouraged to think that leaving these OTMs 'out there' is a good idea. But you already agreed that you usually cover.

Best regards.