The Strap: How Jittery Bulls Can Bet on a Post-Earnings Breakout for Best Buy (BBY)

• Posted by Andrea Kramer
• on December 8th, 2010

Electronics retailer Best Buy Co, Inc. $BBY is slated to confess its third-quarter figures before the opening bell on Tuesday, Dec. 14. Historically speaking, the firm’s earnings resume is rather encouraging, with the company surpassing the Street’s per-share profit projections in three of the past four quarters.

However, what if you want to bet on another post-earnings pop for BBY, but don’t want to put all of your chips in the bullish pot? While a simple long straddle would generate a profit in the wake of a significant move in either direction, its bullishly biased cousin, the strap, dangles a slightly larger carrot on the upside.

So, how does it work? While both the straddle and the strap employ puts and calls at a single at-the-money strike, the latter strategy utilizes twice as many calls as puts. More specifically, to initiate a strap, you would purchase one put and two calls with the same strike and expiration date, resulting in a net debit.

As we alluded to earlier, the objective behind the strap is for the underlying security to make a monstrous move in either direction – but preferably to the upside, since the strategy employs twice as many calls as puts. In fact, should the equity surmount the upper breakeven rail (strike + [net debit/2]) before the options expire, your profit potential is theoretically unlimited, since there’s technically no limit to how high the security could rally.

What’s more, similar to a simple straddle or strangle play, the strap allows you to make money on a significant downside move, too. More specifically, should the stock perforate the lower breakeven rail (strike – net debit), your profit could be substantial, but is limited, considering the furthest the stock could possibly fall is to zero.

What do I have to lose, 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 strap requires you to purchase three options, as opposed to only two for the straddle, your net debit will typically be higher on the play. (In addition, don’t forget to include any brokerage fees, commissions, etc., when calculating your risk/reward scenarios.)

But let’s make this three-tiered option play even more tangible by breaking down a hypothetical strap on BBY. With the shares currently flirting with the $41.50 neighborhood, we’re going to center our strap on the 41 strike. Meanwhile, despite their very short lifespan, we’re going to hone in on December-dated options, which are cheaper than January-dated options (meaning less risk) due to time decay. Of course, if we wanted more time for our position to pan out, we could fork over more cash for longer-term options.

Jumping right in, we’re going to buy one December 41 put, which was last asked at $0.97, and two December 41 calls, which were last asked at $1.46 apiece, resulting in a net debit of $3.89 on the play.

In order to reap a profit on the position, we need the shares of BBY to do one of two things by the end of next week, when December-dated options expire: fall beneath the $37.11 level (strike – net debit), or rally beyond the $42.95 level (strike + [net debit/2]). However, even if BBY remains pinned to the $41 level, the most we can lose is limited to the $3.89 paid to establish the strap.

Fast-forwarding to BBY’s turn in the earnings spotlight… Let’s assume the firm disappoints the bulls, reporting weaker-than-anticipated quarterly earnings and sending the shares retreating to the $35 level. In this instance, both of our December 41 calls will expire worthless, but our 41-strike put will harbor an intrinsic value of $6. Subtracting our net debit of $3.89 paid at initiation, our BBY strap would result in a profit of $2.11.

On the other hand, let’s assume BBY once again beats the Street’s estimates, fueling the shares to the $47 level. In this scenario, our December 41 put will expire worthless, but our two 41-strike calls will each harbor an intrinsic value of $6, or $12 total. Again, subtracting the initial net debit of $3.89, our BBY strap would net us a profit of $8.11.

In other words, while a six-point finish beneath the 41 strike would still net us a decent gain, an equidistant move above the strike price would generate a substantially higher profit.

In conclusion, straps 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 power higher rather than decline. The premium paid – and, ultimately, the maximum potential loss – for this option play will be more than that of the straddle, though, as the investor would be purchasing more options at the start. However, as you can see by the aforementioned example, the potential reward if the stock ticks higher 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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