Updated 2nd time March 24, 2011 @ 12.03 pm: REVIEW OF SUGGESTED TRADE STRUCTURES;
1st- Buy May 40/43 Call Spread for 1.05: this spread can now by sold for ~2.10, so double your money. If you did this as stock replacement then in some sense it was a disaster as the stock is up $6.80 and you are only up 1.o5…..but one considers stock replacement when you think there is a risk to the downside, so there is a trade off, you defined your risk and you gave away upside to do it. At this point you wait it out till May expiration and make the full amount of the spread, not likely stock will be below 43 by then.
2nd- TRADE: BUY the APR 36 / 41 Risk Reversal for .40: If you put this structure on as stock replacement or an outright bullish bet into earnings than you are happy this today. The Apr 36 put is worthless (probably just cover it) and the Apr 41 call is worth 6.00. If you did as stock replacement than you achieved one goal in that you widened the band in which you would get long thus reducing some risk on the downside, but making out as if you were long, albeit a little higher than last nights close. If you have this on i would consider selling a higher strike call against the Apr 41 call that you own and lock in some profits.
3rd- TRADE: BUY the MAY 38/35 Put Spread for 1.05: If you were bearish and bought this spread than in some ways you should feel very relieved as the stock is up 17% this morning and you only risked 1.05. That said it is not fun losing money, but it probably feels a bit better when you are wrong on direction by losing much less than you would have had you been short the stock…..remember one of the main goals of this site is to offer structures to help traders play events or express views with structures that are intended to help preserve capital.
Updated 3/24/11 @ 7:30am: RHT beat the street’s Q4 estimates and guided FY 2012 above street expectations (details below). Stock was up a little over 10% in after hours trading besting the implied move and the avg over the last 8 qtrs. As for the 3 trade structures that I suggested yesterday depending apon your predisposition, 2 would have done very well and one would have done poorly (obviously the May Put Spread). The APR 36 / 41 Risk Reversal will be the structure where you got the most bang for your buck, but there was considerably more risk than defining your risk through the purchase of the May 40/43 Call Spread. After the market opens I will give some specific color to each trade structure suggested yesterday…….
Sales rose 25 percent to $244.8 million in the three months that ended Feb. 28, compared with the $235.1 million average estimate of analysts surveyed by Bloomberg. Per-share earnings, excluding certain items, were 26 cents, beating the 22 cents projected by analysts.
Red Hat expects fiscal year profit, excluding some costs, of 94 cents to 96 cents, the company said. That compares with an average analyst estimate of 93 cents. Sales will be $1.05 billion to $1.07 billion, and analysts had expected $1.03 billion, on average.
EVENT: FY Q4 earnings report tonight after the close. The options market implying ~6.5% move vs the 8 qtr avg move of ~7%.
PRICE ACTION/TECHNICALS: The stock is currently down ~14% ytd, but more interesting to me down almost 20% from the 9 year highs made this past December.
-Chart below shows the stock sitting on its 200 day moving avg (white line) after already breaking through and closing below the fairly important 40 support level. The chart looks precarious to me and a further break below this point could mean a mid 30s stock. That said any good news and even with short interest relatively low at only ~2% of the float, the stock could clearly retrace a bit of its recent weakness at least back to the 50 day moving avg (red line) at ~42.71.
SENTIMENT/VALUATION: as mentioned above short interest is surprisingly low for a high valuation name (we will get to this in a bit) like this at shy of 2% of the float but that measure has come down as the stock has sold off since Dec highs. Wall street analysts (aside from a recent downgrade by JPM) tend to be fairly bullish on the name with 17 buys, 6 holds and only 2 sells, with their avg 12 month price target of ~$48.50 or ~22% higher than current levels.
-As for valuation, most bulls have to kind of hold their noses here and take a bit of a leap of faith regardless of the metric they chose to reinforce their thesis. Not gonna get into too much of the nitty gritty, as Barron’s Tech Trader Daily Blog did a great job here, but the analyst’s downgrade back on Feb 24, was largely to do with valuation and put an Underweight (friendly Wall Street Jargon for SELL) and $32 price target (when the stock was $40.58).
-Stock has long been rumored as a takeover candidate with a $7.6bln market cap it would be very achievable to see a $9-10bln deal, but the valuation ~45x FY12 expected earnings, 8.5x expected sales make it almost impossible for a large player to make the deal accretive, so i wouldn’t be long for just that.
MY VIEW: this a tough one, and i really want to lean short, if you are looking to play for the quarter, the move looks priced a little cheap….I think your ability to make money on at the money straddles will be tough unless you have stronger conviction than I. I would love to lean into the bear case and press the short here but given the stocks under-performance since Dec it will take some fairly downbeat guidance for FY q1 and 2012 to get that to happen and I just don’t have enough conviction. Japan only about 8% of sales for RHT so as we saw last night out of ADBE and JBL, we will see guidance affected by the disaster. I obviously think outright purchases look expensive and would suggest to readers looking to express their views through vertical spreads or possibly risk reversals;
For Longs who are worried about volatility into earnings event consider Stock Replacement: (Sign up for free 1 month trial to read)
MOST CONVENTIONAL STOCK REPLACEMENT- LONG CALL SPREAD:
BUY THE MAY 40 / 43 Call Spread for 1.05
-Buy 1 May 40 call for 1.95 and
-Sell 1 May 43 call at .90
Break-Even on May Expiration:
Upside: stock btwn 41.05( up ~5%) and 43 (up ~10%) can mkae up to 1.95, above 43 make full 1.95
Downside: btwn 40 and 38.95 lose up to 1.05 in premium you paid for the spread, below 38.95 lose all……BUT YOU HAVE DEFINED YOUR RISK.
MUCH RISKIER STRUCTURE–BUT REALLY NOT ANY RISKIER THAN BEING LONG AT CURRENT LEVELS-Higher Risk, Higher Reward.
TRADE: BUY the APR 36 / 41 Risk Reversal for .40
-Sell 1 APR 36 Put at .60 and use proceeds to
-Buy 1 APR 41 Call for 1.00
Break-Even on APR Expiration:
Upside: 41.40 or higher (up ~5%) have unlimited profit
Downside: btwn 41.40 and 41 you can lose up to the .40 in premium that you paid for the structure, WORST CASE- stock below 36 (down 7.5%) and you are Put the stock and have and additional .40 loss of the premium that you paid…..
TRADE STRUCTURE RATIONALE:
For longs who think as I do that there are potential issues in tonight’s earnings report to cause volatility you may want to consider stock replacement (selling your long and replicating the economic long exposure through options). I find this structure interesting because i am effectively creating a band in which i would get long the stock again at 2 different levels, one down 7.5% and one up 5%…this way i mitigate the risk on the downside that the options market is implying…..now don’t be fooled here, if the stock were to sell off and head towards the Put strike you are short you will suffer mark to market loses, and the volatility of the Put will shoot up, but if you wait till expiration and the stock settles down you will probably be better off than if you were just long stock. And remember this structure will eat up some margin as you are naked short that Put. For those of you worried about tail risk you could consider selling a Put Spread and buying the Call…..
BEARISH TRADE INTO EARNINGS REPORT:
TRADE: BUY the MAY 38 / 35 Put Spread for 1.05
-BUY 1 May 38 Put for 1.95 and
-Sell 1 may 35 Put at .90
Break-Even on MAY Expiration:
Upside: btwn 38 and 39 you can lose up to 1.05 in premium that you paid, above 39 lose all
Downside: btwn 37 and 35 can make up to 1.95, below 35 make 1.95