Rolling the Dice on a Post-Earnings Retreat with a Hypothetical Strip on Research In Motion (RIMM)

• Posted by Andrea Kramer
• on December 15th, 2010

BlackBerry behemoth Research In Motion Limited $RIMM will take the earnings reins after the closing bell tomorrow. Analysts, on average, are expecting the firm to record a third-quarter profit of $1.64 per share on about $5.4 billion in revenue. From an historical standpoint, the tech titan has bested the Street’s per-share earnings predictions in three of the past four quarters, according to Thomson Reuters.

While RIMM’s relatively impressive earnings resume might have the bears on edge, one options strategy could calm those pre-earnings jitters: the strip — cousin of the long straddle, and skeptically skewed sister of the strap. This three-tiered option play allows pessimistic options speculators to gamble on a post-earnings retreat, but hedge his bets in the event of – and even profit from – a significant move to the upside. However, before we break down our theoretical strip on RIMM, let’s first examine the ABCs of the strategy.

While both the straddle and the strip employ puts and calls at a single at-the-money strike, the latter strategy utilizes twice as many puts as calls. More specifically, to initiate a strip, you would purchase one call and two puts with the same strike and expiration date, resulting in a net debit.

As we’ve already mentioned, the objective behind the strip is for the underlying security to make a monstrous move in either direction – but preferably to the downside, since the strategy employs twice as many puts as calls. Should the stock perforate the upper breakeven rail (strike + net debit), the investor’s profit could be substantial, and is calculated by subtracting the net debit from the call’s intrinsic value. However, an equidistant move beneath the lower breakeven level (strike – [net debit/2] before the options expire would generate even grander gains, due to the double dose of long puts.

So, what’s the catch, you ask? Should the underlying stock fail to penetrate either breakeven rail, the good news is that – like the straddle strategist – your maximum risk is capped at the initial premium paid for the options. However, since the strip requires the investor to purchase three options, as opposed to only two for the straddle, the net debit will typically be higher on the play.

Plus, since demand for at-the-money options typically increases ahead of major events like earnings – as measured by implied volatility – the options you buy may be more expensive than usual. (In addition, don’t forget to include any brokerage fees or commission costs in your calculations.)

Now that we’ve got the basics out of the way, let’s breathe even more life into this bearishly biased volatility play by dissecting a hypothetical strip on RIMM.

With the shares currently lingering in the $59 region, we’re going to employ 60-strike options for our strategy. Meanwhile, since December-dated options expire after the closing bell on Friday – just 24 hours after RIMM’s earnings release – we’re centering our strip on January-dated options, which will allow more time for any post-earnings moves to play out. However, those with less patience – and capital to risk – could utilize December 60 options for their strip, which are much cheaper (meaning less cash on the line and narrower breakeven rails) due to their lack of time value.

Diving right in, we’re going to buy one January 60 call, which was last asked at $2.90, and two January 60 puts, which were last asked at $3.85, resulting in a net debit of $10.60 ([$2.90 x 1 contract) + ($3.85 x 2 contracts)] per trio of options.

As a result, we need the shares of RIMM to penetrate one of two breakeven rails within the next several weeks, before January-dated options expire: the $70.60 level (strike + net debit), or the $54.70 level (strike – [net debit/2]). However, even if RIMM remains subdued in the $59-$60 neighborhood over the short term, the initial $10.60 paid to establish the strip is the most we can possibly lose.

Okay, with that out of the way, let’s fast-forward to tomorrow night… First, let’s assume RIMM extends its winning streak in the earnings spotlight, sending the shares soaring to the $72 level – an area the stock hasn’t explored since May 2010. In this case, any dejection you may feel for your initial bearish stance will likely dissipate, as your strip will still net you a profit. More specifically, while the two 60-strike puts will expire worthless, the 60-strike call will be worth $12 – $1.40 more than your initial net debit of $10.60.

On the flip side, let’s assume RIMM disappoints during its turn on the earnings stage, sending the shares reeling to the $48 level, which has contained most of the equity’s pullbacks since the midway point of the year. In this best-case scenario, your 60-strike call will expire worthless, but your pair of January 60 puts will each harbor an intrinsic value of $12, or $24 combined. Subtracting the initial $10.60 paid to construct the strip, your position would result in a healthy gain of $13.40 – more than double your money.

In other words, while a 12-point finish above the 60 strike would still net us a pretty penny, an equidistant move below the strike price would generate a substantially higher profit.

In summary, strips are best suited for traders expecting the stock to experience volatility on the charts, but who think the odds are greater for the equity to backpedal rather than rally. The premium paid – and, ultimately, the maximum potential loss – for this option play will be more than that of the straddle, though, as you’d be purchasing more options at the start. Furthermore, since many volatility plays – including the strip – are often initiated ahead of a major event, you’ll likely have to shell out more cash than usual for in-demand, at-the-money options. However, as you can see by the aforementioned example, the potential reward if your pessimistic predictions come to fruition may be worth it.

For more options-centered educational content, or to see which stocks are heating up the options pits each day, visit my home base at schaeffersresearch.com.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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