Last week I wrote an article explaining why I thought that Green Mountain Coffee Roasters (GMCR) would move higher after its earnings announcement. I was totally wrong. The stock fell by nearly $5.
In one of my Terry’s Tips portfolios, I placed a diagonal spread which would do best if GMCR moved higher (as I expected it would at the time). In spite of its moving lower, I closed out the spread the day after earnings for a 30% gain after commissions. Not a bad return when you are totally wrong.
Today I would like to propose a similar diagonal spread to be used on another company which will announce earnings next week (on Wednesday, after the close).
I really don’t know much about Buffalo Wild Wings (BWLD). I have never visited one of their restaurants and don’t think I have ever seen one in New England. But options on the stock are extremely interesting to me. The Feb-13 options that expire on Friday, February 15th carry an implied volatility (IV) of 80 while longer-term options such as the Jun-13 series has an IV of only 36. That means the February options are more than twice as expensive as the June options.
I would like to buy June options and sell February options before Wednesday’s announcement.
I learned everything I could about the company, and wrote an article for Seeking Alpha on it – How To Play The Buffalo Wild Wings Earnings Announcement Next Week. The most important thing I learned was that some big options players were betting that the stock would tank after earnings (and Jim Cramer suggested selling it as well). I thought the P/E was too high considering its growth rate which put me in the bearish camp as well. All these ideas suggested to me that the stock was more likely to fall next week than it is to move higher.
With that scenario in mind, here is the spread that I will be buying (for a $5000 portfolio) with the stock trading about $77:
BTO (buy to open) 6 BWLD Jun-13 85 calls (BWLD130622C85)
STO (sell to open) 6 BWLD Feb-13 80 calls (BWLD130216C80) for a debit of $1.40 (buying a diagonal)
If the stock stays flat or goes down by any amount by Friday’s close, the Feb-13 80 calls will expire worthless and I will end up holding Jun-13 85 calls which should have a value well in excess of $1.40 (they are worth $3.60 right now). The greatest gain for this spread would be if the stock edged up to $80 and the February calls expired worthless while the June calls might be worth more than they are right now. You can see how this spread can make money even if you aren’t right about how you think about the stock.
The above diagonal spread would require a maintenance requirement of $500 per spread in addition to the $140 cost to buy the spread. This is not a loan like a margin purchase would involve, but the broker puts a hold on $500 in your account that can’t be used for other purposes. The reason for this maintenance requirement is that theoretically you could lose that much if the stock rose sharply and you had to buy back the Feb-80 calls, and then you did nothing for five months and let the June options expire worthless. Of course, since the June options have five additional months of life, they would have a good value if you sold them next week instead of waiting. This means that from a practical standpoint, the $500 potential loss is not really totally at risk because you plan to sell the June options next week while they still have a good value.
Just in case I am wrong in my assessment of this company, I will also place the following diagonal spread:
BTO (buy to open) 4 BWLD Jun-13 70 puts (BWLD130622P70)
STO (sell to open) 4 BWLD Feb-13 75 puts (BWLD130216P75) for a debit of $.90 (buying a diagonal)
There will not be a maintenance requirement on this spread because you can’t lose $500 on both this spread and the call spread placed above. This put spread will do best if the stock falls to $75 and expires worthless while the June 70 puts should increase in value (currently $3.80). If the stock moves higher, above $75, the February 75 puts expire worthless and the June 70 puts will retain some value because they have five more months of remaining life.
If the stock ends up between $75 and $80, both spreads should make excellent gains. Losses should come about only if the stock moves over 8% on the upside or over 10% on the downside. That is quite a large range of possible prices for the two days the options will be held.
If you are totally bearish on the stock you would only place the diagonal call spread. If you are strongly bullish on the stock you would only place the diagonal put spread. It seems a little ironic that the best spread to buy if you think the stock is headed down uses calls while the best spread to buy if you think the stock is headed higher uses puts. But that’s the way it is in the crazy world of options.
I expect these spreads will yield at least the 30% I made last week while being wrong about GMCR. Just imagine how much you could make if you were right.