Do Earnings and Butterflies Mix? A Case Study with Sears (SHLD)

Welcome to Brian Overby and TradeKing on this submission to the CBOE Community. Brian originally submitted this a few weeks ago. Do to a few regulatory issues, we both decided to wait until we got the OK, which we did. With Sears earnings a few days away, we thought this was still very timely. So welcome TradeKing and Brian! In this post for advanced options traders, TradeKing’s Brian Overby uses Sears (SHLD) to demonstrate a bearish earnings play using butterflies.

Recently, Credit Suisse issued guidance on stocks they think are poised to drop: One name from their list that jumped out at me is Sears Holding (SHLD). This retailer with an “expensive” stock price was the only large-cap Credit Suisse expects to see a decline in EBITDA (earnings before interest, taxes, depreciation and amortization.) Sears plans to announce earnings on 5/19, and May option expiration Friday just happens to be 5/20, the day after – a nice little coincidence. While SHLD’s price drop has already begun since CS’s 4/14 report, Thursday’s earnings report makes this a trade with potentially a little juice left in it. (As advanced options traders know, options tend to lose value due to implied volatility drops post-earnings, a phenomenon known as “vol crunch”.)

I’ll be highlighting stock-pick lists like these now and then, since they can offer a prime opportunity to apply options trading theory to a “real-world” practice. Keep in mind: TradeKing doesn’t give specific buy or sell recommendations, and I won’t be trading these moves myself. Whether to trade or not is totally up to you. My purpose here is simply to talk you through a theoretical trading scenario to see what it can teach us.

As is usually the case before an earnings report, the implied volatility (IV) has spiked a little for May SHLD options because of the volatility the earnings report could bring to the stock price. See the implied volatility index mean vs historical volatility chart that can be found on the CBOE site and on the TradeKing web-site. This chart as of the close on 4/20 shows the IV index (37%) for SHLD quite a bit higher than the 30-day historical volatility (28%) of late for the stock. Our theoretical prediction for implied volatility for the May options is that IV will decline after the earnings report is released. (While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.)

Now that the stage is set, what is a possible trade that may benefit if Credit Suisse’s forecast is correct and the IV does decline after the earnings report is announced?

Many don’t think of butterflies as a directional trade – after all, the b-fly trader usually wants the stock to go to a specific price and stay there. (This description of Long Put Butterflies, including the trade’s potential risks, will brush you up on the strategy.) BUT, if that specific price point you want the stock to gravitate to is below the current market price, then this neutral trade becomes a bearish trade. Let me explain in an example. (Note: multiple-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments; the max risk for a butterfly is is the net debit paid.)

With the stock at 76.05 and 5 days to Saturday expiration date of the May options, let’s look at a put butterfly in Sears.

Using the mid point on all the quotes, we could construct the trade as follows:

Buy 1 May 65 Put   @  0.08
Sell 2 May 70 Puts  @  0.22
Buy 1 May 75 Put   @  1.27

Net Debit for the butterfly would be 0.91.
Commission at TradeKing would be $7.55 for the entire trade.

So total cost for this 1x2x1 butterfly is $91 + $7.55 or $98.55.

At expiration 5 days from now, let’s work out the numbers:

Max risk is the net debit paid: 0.91
Max gain is width of the spread (5) minus debit paid (.91): 4.09
Break-evens are at: 65.91 and 74.09

What makes this trade interesting?

1) The obvious: the risk/reward at expiration, your max risk is 91 cents and your max reward is $4.09.

2) The range: if the stock finishes at expiration within an $8.18 range (between 65.91 and 74.09), the trade either breaks even or profits. $8.18 on stock price at $76.05 is about a 11% price range. Now don’t forget the stock is currently at $76.05 so it does have to go down to be profitable. If it’s above 75 at expiration you will lose your entire investment.

3) Not so obvious: after the trade is established a butterfly would like the IV to decrease. So if you do hang around the trade until the earnings report, the trade may benefit if IV decreases and you are correct on your forecast and the stock is withing the profitable range between the break-even points.

4) Also: the max gain is only really possible at expiration and the stock is at the middle strike (70).

That said, no trade is without risks – and this one happens to be a risky one, suitable for advanced options traders. Other points to consider:

If you choose to place a trade like this, your plan should be not to go too big and also involve riding the trade to the earnings announcement date (most likely). It is a risky trade and more than likely you it will either be a big gainer or you will lose it all. This is because the earnings date is so close to expiration.  As with all option strategies, have a plan and stick to it. Know what you want for a profit and what you are willing to take as a loss before entering the trade.

Brian Overby, TradeKing’s Options Guy