Options Trade of the Day: Strangling Sprint Nextel Corp. Ahead of Earnings

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Sprint Nextel Corp. ( S ) is expected to report a second-quarter loss of 19 cents per share on July 28. Earnings reports can spur large moves in a security if a company matches or misses these expectations. Options traders are betting on just such a development for S, as speculators are piling into both puts and calls on this telecommunications concern.

Overall, call volume has swelled to more than 60,000 contracts today, with traders sending some 57,000 of these calls across the tape on S' August 5 strike. Meanwhile, put volume has spiked to about 30,000 contracts, with 22,900 of these puts crossing on S' August 4 strike.

Zeroing in on these most active strikes, I uncovered what appears to be the initiation of a strangle position on S heading into the company's earnings report. Specifically, a block of 2,500 S August 5 calls traded at 12:56 p.m. Eastern time on the New York Stock Exchange (NYSE) for the ask price of $0.24. At the same time on the same exchange, two blocks of August 4 puts, totaling 2,500 contracts, traded at the ask price of $0.03. By implementing this strategy, the trader needs S to move sharply before these options expire on Aug. 20; direction doesn't matter.


S August 5 call and August 4 put volume

For those not familiar with this options strategy, a strangle is the simultaneous purchase or sale of an equal number of puts and calls on a given underlying stock with the same expiration date but different strike prices. The strangle purchaser is looking for a large move by the stock; one that exceeds either strike level by more than the amount of the premium paid for both options.

The Anatomy of a Sprint Nextel Corp. Strangle

Drilling down on today's S strangle, the trader purchased 2,500 August 5 calls for $60,000 -- ($0.24 * 100) * 2,500 = $60,000. At the same time, the trader also purchased 2,500 August 4 puts for $7,500 -- ($0.03 * 100) * 2,500 = $7,500. The total outlay for this position would be $67,500 -- $60,000 + $7,500 = $67,500.

S strangle breakdown

There are two ways of determining the maximum profit on a strangle position. If S jumps higher, then the maximum profit is theoretically unlimited, as there is no cap to how high the shares can rally. If S plunges, the maximum profit is limited to the purchased put strike minus the total debit paid. For this position, the maximum profit from a downside move is $3.73, or $373 per contract.

There are two breakeven points for this position. They are calculated by adding the net debit paid to the purchased call, and subtracting the net debit paid from the purchased put. For the example, the breakevens are $5.27 -- 5 + 0.27 = $5.27 -- on the upside, and $3.73 -- 4 - 0.27 = 3.73 -- on the downside. Finally, the maximum loss is limited to the net debit paid upon entering the position. Below is a chart for a rough visual representation:

S strangle profit/loss chart

Implied Volatility

Traders should not be afraid of rising implied volatility following the initiation of a strangle position. An increase in implieds increases the value of the purchased options, allowing the trader to collect a higher return by selling (to close) the position. At the time of the trade, implieds for the S August 5 call were 47.94%, while the implied volatility for the August 4 put rested at 60.62%. For comparison, the stock's one-month historical volatility came in at 29.20% as of the close of trading on Friday, meaning that both options are relatively expensive at the moment.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Options

Referenced Stocks: S

Schaeffer's Investment Research

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