Options Trade of the Day: Betting Against Cree Inc. Ahead of Earnings

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Cree Inc. ( CREE ) is scheduled to release its quarterly earnings report after the close of trading on Oct. 19. Analysts are currently looking for a profit of 58 cents per share from the firm, more than doubling Cree's profit of 25 cents per share in the same quarter last year. Historically, the company has bested Wall Street's expectations in each of the prior four reporting periods, with an average upside surprise of nearly 22%.

Technically speaking, the stock has rebounded off its September lows, but has run smack into resistance in the $57-$58 region. CREE has not closed a session above this area since late August.

Daily chart of CREE since August 2010

Overall, CREE's options volume was heavily call-centric today, with more than 9,000 of these bullishly oriented contracts changing hands so far, more than doubling the stock's daily average. The most popular strike on the session has been CREE's October 55 call, where about 2,400 contracts have traded.

Looking past the soon-to-expire October series, we find that the most active November options are the 45 and 57.50 puts. While taking a closer look at this volume, I stumbled across what appears to be a bearish debit spread on CREE. Specifically, a block of 2,500 November 45 contracts, marked "spread," traded on the Chicago Board Options Exchange ( CBOE ) at 11:13 a.m. Eastern for the bid price of $0.99, or $99 per contract, indicating that the contracts were most likely sold to open.

The second leg of this position was found on the November 57.50 put, as a block of 2,500 contracts traded at the same time on the same exchange for the ask price of $5.34, or $534 per contract. This block, too, was marked "spread." Given this data, we could be looking at the initiation of a vertical put spread, or a debit spread , on Cree Inc.

CREE option volume details

The Anatomy of a Cree Inc. Vertical Put Spread

Breaking down this vertical put spread, the trader would have purchased 2,500 November 57.50 puts for a total outlay of roughly $1.33 million -- (5.34 * 100) * 2,500 = $1,335,000. The second leg of the debit spread helps to offset the cost of the overall position. Specifically, the trader sold 2,500 November 45 puts for a total credit of $247,500 -- (0.99 * 100) * 2,500 = $247,500. Combining this leg of the trade with the purchased November 57.50 put lowers the total cost of the entire position to about $1.09 million -- $1,335,000 - $247,500 = $1,087,500.

The addition of the sold November 45 put also lowers breakeven on the trade. To arrive at breakeven, we subtract the credit received from the sold November 45 put from the debit incurred by purchasing the November 57.50 put. Doing so, we arrive at a cost of $4.35- $5.34 - $0.99 = $4.35 -- or $435 per contract. As a result, breakeven for the position rests at $53.15 per share, with the trader now needing CREE to fall roughly 5.1% from its current perch near $56.

CREE vertical ratio put spread details

The maximum profit on the long vertical put spread is calculated by subtracting the total debit paid from the difference between the sold November 45 strike and the purchased November 57.50 strike. In this case, the maximum profit is $8.15 -- (57.50 - 45) - 4.35 = $8.15 -- and is reached if CREE drops to $45 per share when the options expire. Below is a chart for a rough visual representation of the trade's profit/loss scenario:

CREE vertical ratio put spread profit/loss chart

Implied Volatility

After the vertical put spread has been entered, increasing implied volatility is pretty much neutral to the overall position, as it lifts the value of both the sold option and the purchased option. At the time of the trade, implieds for the November 45 put were 72.74%, while the implied volatility for the November 57.50 put was 67.61%. For comparison, CREE's one-month historical volatility was perched at 35.77% as of the close on Wednesday.

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This article appears in: Investing , Options

Referenced Stocks: CBOE , CREE

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