Tipping That Pre-Earnings Volatility Play to the Bearish Side

Poultry behemoth Tyson Foods $TSN will step up to the earnings plate bright and early on Monday. Ahead of the event, Credit Suisse highlighted weakness in the chicken industry, but said supplies could get a boost from the impact of hot weather on bird weights. Against this mildly skeptical backdrop, we come to a common dilemma — while earnings season is typically ripe for directionally neutral plays like the long straddle and strangle, what if you have a slightly bearish view on the stock?

By employing the lesser-known strip strategy, pessimistically slanted options speculators can gamble on a post-earnings retreat, but hedge their bets in the event of – and even profit from – a significant move to the upside. Before we jump into a hypothetical strip on TSN, let’s first break down 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.

Strip Strategy

Strip Strategy

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 theoretical strip on TSN.

With the shares currently lingering in the $17 region, we’re going to employ August 17-strike options for our strategy. Specifically, we’re going to buy one August 17 call, which was last asked at $0.60, and two August 17 puts, which were last asked at $0.55, resulting in a net debit of $1.70 ([$0.60 x 1 contract) + ($0.55 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 August-dated options expire: the $18.70 level (strike + net debit), or the $16.15 level (strike – [net debit/2]). However, even if TSN remains subdued in the $17 neighborhood over the short term, the initial $1.70 paid to establish the strip is the most we can possibly lose.

Okay, with that out of the way, let’s fast-forward to next week… First, let’s assume TSN reports stronger-than-anticipated earnings, sending the shares soaring to $20 – a level that’s capped the stock’s weekly advances since April 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 17-strike puts will expire worthless, the 17-strike call will be worth $3 – $1.30 more than your initial net debit of $1.70.

On the flip side, let’s assume TSN disappoints during its turn on the earnings stage, sending the shares reeling to the $15 level. In this best-case scenario, your 17-strike call will expire worthless, but your pair of August 17 puts will each harbor an intrinsic value of $2, or $4 combined. Subtracting the initial $1.70 paid to construct the strip, your position would result in a healthy gain of $2.30 – almost double your money.

In other words, while a 3-point finish above the 17 strike would still net us a pretty penny, a narrower move below the strike price would generate a substantially higher profit.

Hypothetical Pre-Earnings Strip on TSN

Hypothetical Pre-Earnings Strip on TSN

In summary, strips are best suited for traders expecting the stock to experience volatility on the charts, but 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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