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100% Gain in One Week Possible With Nike Options Trade?
Nike (NKE) has fallen on hard times of late, falling from $68 in early December to $52.59 at the close on Friday. Earnings will be announced after the close on Tuesday, the 28th. Whisper numbers are about 10% higher than public estimates, and options are priced for a higher price after the announcement.
I am an options trader and rarely ever buy stock. I really don’t know if Nike will go up or down after the announcement, but there are some interesting features of the option prices that have caused me to take an interest in the company this week. As I often repeat in this newsletter, implied volatility (IV) of the option prices is the major reason that option prices are “high” or “low” compared to other option prices.
Most of the time, our basic strategy involves buying calendar spreads at a variety of strike prices. A calendar spread (also called a time spread) consists of coincidentally buying and selling either put or call options at the same strike price. The option you buy always has a longer time life than the option you sell. Our gains come from the higher decay rate of the short-term options that we have sold compared to the lower decay rate of the longer-term options that we have bought.
Most of the time, when we buy these calendar spreads, the IV for the options we buy is greater than it is for the options we sell. This means we are buying relatively more expensive options and selling relatively cheap options. We don’t particularly like this, of course, but it is usually the nature of option prices. Most of the time, we manage to make money on our calendar spreads in spite of this reality (which we call an IV disadvantage).
When a company is about to announce earnings, the IV disadvantage often turns into an IV advantage. When a company announces, there is often a big move in the stock in one direction or the other immediately after the announcement. The likelihood of this big move causes a surge in the option prices for the series which expires directly after the announcement. In other words, IV soars for that series and almost always becomes greater than the longer-term series that follow.
The NKE option series which expires directly after the June 28 post-market announcement is the 1Jul16 series which expires on the following Friday. IV for this series has surged to 53. This compares to an IV of 30 for the 29Jul16 series which expires 28 days later than the 1Jul16 series. This is a humungous IV advantage. It enables you to buy relatively cheap options and sell relatively expensive options which have a long way to fall to get to their intrinsic value on expiration Friday.
When you buy calendar spreads, you choose a strike price which is closest to where you think the stock price will end up. Since I really have no idea where that price might be for NKE, I take my best guess and select strike prices accordingly. My best guess is that NKE has fallen so far already that the chances are better that it might move higher after tomorrow’s announcement. After all, it is a good company, and they are still celebrating LeBron James’ victory in Cleveland (and he is a big spokesman for Nike). With the stock closing at $52.59 on Friday, I will pick the 52.5 and 55 strike prices. If I wanted to guess that the stock would fall after the announcement, I would pick the 50 strike as well.
Here are the trades I will make Monday or Tuesday (although the quantities will be greater):
Buy to Open 1 NKE 29Jul16 52.5 put (NKE160729P52.5)
Sell to Open 1 NKE 1Jul16 52.5 put (NKE160701P52.5) for a debit of $.43 (buying a calendar)
Buy to Open 1 NKE 29Jul16 55 call (NKE160729C55)
Sell to Open 1 NKE 1Jul16 55 call (NKE160701C55) for a debit of $.43 (buying a calendar)
I may have to adjust these prices a bit to get an execution, but at Friday’s close, these prices were possible. Each spread will cost me $43 plus a $2.50 commission (the rate paid by Terry’s Tips’ subscribers at thinkorswim – many people become subscribers primarily to get this low rate which applies to all their trades – the normal commission rate at thinkorswim for a single option spread trade is $7.80).
So I will be shelling out a total of $86 plus $5, or $91 for each pair of spreads I buy. I am planning to close out (sell) both spreads near the end of the day on Friday, July 1st. I have selected puts for the 52.5 strike and calls for the 55 strike because I am hoping that the stock ends up at some price between $52.50 and $55 on Friday. If it does, then both the puts and calls I sold that will expire that day will be out of the money. I should be able to buy them back for $.05 or less near the end of the day. Thinkorswim does not charge a commission if you buy back expiring options for $.05 or less.
The big question will be what value the 29Jul16 options will have next Friday. To get an idea, I need to check back and see what the likely IV will be of those options at a time when there is no earnings announcement on the horizon. I found that a typical IV for the series with 28 days of remaining life was 27. That is 3 less than the current IV of those options. This means that those option prices will fall, but not a whole lot.
If you go to the CBOE option calculator and enter in a price of either $52.50 or $55 and the same strike, select 28 days for the time period, and 27 as the IV, and hit Calculate, you will find that the option will be trading about $1.56 for the 52.5 strike or $1.64 for the 55 strike. That means that if the stock ends up at either of the strike prices I selected, I will collect almost twice as much for a single sale as I paid for both spreads. The other spread will also have some value. If the stock is $2.50 away from one of the strikes, the CBOE calculator says the remaining long option will have a value of about $.65 which is still greater than what I paid for either spread, even after paying $.05 to buy back the expiring option.
If these option prices prevail next Friday and the stock ends up at any price between $52.50 and $55, I should be able to collect a total of about $225 (less $10 to buy back the expiring options less $2.50 for commissions, for a net of $212.50). This amount is well more than double my total $91 investment for the pair of spreads.
What could go wrong? First, IV might not be as high as 27. If the stock stays flat, option prices might fall because they are based on the expected volatility of the stock – a flat stock suggests low future volatility. Second, the stock might fluctuate so much that it moves well beyond the two strike prices I have picked. That is the greatest fear. But if that happens, volatility might even get greater than 27 for the options I will be selling, and that might result in a higher than expected price when I sell.
I feel highly confident about these spreads. If the market tanks early in the week, I would buy spreads at the 50 strike as well. As usual, I would like to remind everyone that options involve risk, and you should only invest money that you can truly afford to lose.
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Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts. seth@terrystips.com
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I look forward to having you on board, and to prospering with you.
Terry
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