Name that Trade: LULU Edition

by Enis August 27, 2012 3:00 pm • Commentary

LULU caught my eye today when I was screening through potential volatility plays on single names with high implied volatility.  LULU is scheduled to report earnings on September 7th, so next Friday, and as a result, September implied volatility is quite elevated.  The stock is trading at 64.35, and the Sept 65 strike implied volatility is 64.5.  

Given that LULU has averaged a 10% move on earnings over the past 8 quarters, the Sept 65 straddle priced at 8.75 does not seem totally out of whack.  But what did surprise me is when I looked at October expiry.  The October expiry 65 strike options are currently priced at 52.5 implied volatility, or 12 points below Sept.  Using our implied move calculator , and using 18 days to first expiry and 38 days to second expiry, I get a forward implied volatility of 38.5, meaning the market expects realized volatility between September expiry and October expiry to be around 38.5.  That looked too low to me based on LULU’s realized volatility history, so I wanted to look for trades where I sell September options to buy October options.

First, here’s what September expiry looks like:



As you can see, the put wing is especially elevated, with the Sept 50 puts (almost 25% away) worth 0.80, so a big move is certainly expected by options traders.

Here is what Oct looks like:



When comparing Sept vs. Oct, you can quickly see that the implied volatility difference grows as we go lower in strikes.  For example, the September 50 puts that I mentioned above around 84 implied vol, while the October 50 puts are priced at 65 implied vol, a 19 point difference, much larger than the 12 point difference for the 65 strike.  The options market is basically saying that if LULU is going to make a move below $50 in the next 2 months, it is very likely going to be due to an earnings event.  The chance that LULU moves below $50 on a non-earnings related macro or micro event in the market is priced comparably low, so most of the $50 put premium is priced into September.

Though I’m initiating no trades in LULU today, the difference between Sept and Oct implied vol does seem rich to me.  I don’t have a strong view on the micro story surrounding LULU, though my general bearish bent on the markets tends to have me looking at put calendars rather than call calendars on most high vol names.  However, since I’ve been hurt on my bearish bets recently, I am looking for more directionally-neutral trade structures.  One possible structure that I am considering ahead of earnings next week is the following:

Sell the Sept 55 / 72.5 strangle around $2.80

Buy the Oct 55 / 72.5 strangle around $4.00

This would cost me a net debit of $1.20, but the trade would be profitable on most scenarios following earnings.  The main risk would be a very large move in either direction (25% plus) that would cause both options to trade at intrinsic value (costing me my $1.20 in premium).  Outside of that, the trade should be a small to medium winner in most cases.  I am going to keep my eye on this trade as LULU earnings approaches.