Monday, September 14, 2009

Best Buy Earnings

With Best Buy (BBY) earnings on the docket for Tuesday, the Options Action pundits took a stab at a couple earnings plays on the retail behemoth on Friday night. Given the strong run BBY has put in over the last few months, in addition to the questionable spending prowess of the current consumer, the over riding tone was bearish going into Tuesday's third quarter earnings announcement. Let's break down one of the strategies ; the 1 x 2 put spread.

Over the past 4 quarters BBY has moved an average of 10% after earnings. With BBY currently trading around $40, the front month (Sep) ATM straddle is trading for $3, implying about an 8% move between now and Friday. A quick look at the volatility chart shows implied vol has lifted a bit off of its 52 week lows into earnings, but probably not enough to get excited about (click image to enlarge).

[Source: IVolatility]
The Play
The 1x2 put spread, is also referred to as a vertical ratio spread. Think of it as buying a put spread, with an additional short put. The recommendation was to buy a Sep 37.50 put and sell two Sep 35 puts for a net debit around $.20.

So what's the bet?

Like a normal 37.50-35 put spread, we want the stock to reside at or below $35. However, since we're short an additional 35 put option, we can potentially lose money if the stock drops too much. Based on the risk graph below, our profit zone resides between $37.35 and $32.65. So, although this is a bearish trade, if BBY drops more than 18% (below $32.65), it could turn into a loser. However, given that the current ATM straddle is implying a move of merely 8%, an 18% drop is certainly not likely (click on image to enlarge).

[Source: EduTrader]
Yet another way to think of the vertical ratio spread is the inverse of a ratio back spread. Those selling ratio backspreads (i.e. buying a vertical ratio spread- buy a higher strike put, sell multiple lower strike puts), will have a profit/loss graph that is the inverse of those buying the ratio bacskpread (sell a higher strike put, buy multiple lower strike puts). If you were to flip the risk graph above upside down it would look like a put ratio backspread. Take a look at the risk graph juxtaposed with the stock chart (click to enlarge).

[Source: EduTrader]
If BBY remains above $37.50, which would occur if there is a neutral to positive reaction to tomorrow's earnings, our risk is the net debit we paid at trade inception. Currently that's a measly $.20. Typically I don't like straight directional plays into earnings announcements, but this type of play is certainly tempting. The premium received from selling the additional 35 put aided in dropping the net debit paid, thereby reducing our upside risk.

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