Trade Update $GME – Taking Nice Profit on Put Butterfly Near Target

by Enis December 11, 2013 10:11 am • Commentary

When we first put on the GME trade, our rationale was that the stock had broken the important $49-$50 support area on important fundamental weakness, so we expected lower prices over the next several weeks.  That has indeed been the case, with GME trading about 5% lower vs. where we first entered the put butterfly.

The stock has found support around $45, holding that level since last week.  With GME close to the $46 midpoint of our put fly structure, and the put butterfly worth more than $2, we are going to take the trade off for a nice win today.

Action:  Sold to Close GME ($46.07) Dec21st 50/46/42 Put Fly at $2.11 for a $0.85 gain

Part of the reason that we took the gain today is that the bulk of the remaining decay in the trade will take place over the last few days before expiry, so Wednesday, Thursday and Friday of next week.  That happens to coincide with the period directly after the FOMC announcement next week, and we do not want to hold the structure through that potential market-moving event.

Original Post Nov 25th, 2013:  New Trade $GME – Rental Income

Add GME to the list of big 2013 winners that has recently experienced a significant technical breakdown.  GME reported Q3 earnings last week, and actually beat by a penny, with better than expected revenues as well.  But earnings guidance was slightly weaker than expected for the crucial 4th quarter (about 65% of GameStop earnings come in the 4th quarter), and the stock closed down 7% on Thursday on its highest volume day in more than 2 years.

We posted a Deep Dive on GME about 6 weeks ago, noting:

Reading the rest of the 10-Q, you get the sense that this is a declining company.  Net sales across all its major categories have declined 5-25% over the last year.  The company has been in cost cutting mode, so its net profit has only declined about 5%.  But GME management simply blames the sales decline on the fact that we are in the late stage of the console cycle.  Management does acknowledge that digital delivery of games is the wave of the future, but lays out little besides standard, cliched lines about “new investments” in the digital space.

Analysts have modeled in modest profit growth over the next couple years, clearly expecting a pick up in sales when the new console cycle gets underway.  The Playstation 4 and the Xbox One are both going to be launched in the next few months, just in time for the 2013 holiday season.  Interest in video games is expected to increase, and GME management is confident that it can cash in on that excitement.

With the new gaming console cycle about to hit full speed in the holiday season, market participants were hanging on to management’s every word on last week’s conference call.  The new console market is going to be the key to growth, but in the short-term, GME’s margins are going to be lower than normal, which was the primary reason for the negative reaction.

While both the Playstation 4 and the Xbox One are likely to see strong sales in the 4th quarter, I view GameStop’s reaction to earnings as a sign of a tired stock in the short run rather than a long-term change in the story.  We laid out the many signs of technical deterioration in that Deep Dive post, and the recent break leaves the stock with ample overhead supply:

GME daily, Courtesy of Bloomberg
GME daily, Courtesy of Bloomberg

The stock could now be stuck between 40 and 50 after the recent breakdown, with no major news catalyst out for the next month.

TRADE:  GME ($48.15) Buy the Dec 21st 50/46/42 Put Fly for $1.26

-Buy 1 Dec 21st 50 Put for 3.14

-Sell 2 Dec 21st  46 Puts at 1.09

-Buy 1 Dec 21st  42 Put for 0.30

Break-Even on Dec 21st Expiration:

Profits: Between 43.26 and 48.74 of up to 2.74, with max profit of 2.74 at 46

Losses: Up to 1.26 between 42 and 43.26, and between 48.74 and 50, with max loss of 1.26 below 42 and above 50.

Trade Rationale:

GME has broken down below the important 49-50 support area, so we want to play for a move back to $46, which is near the midpoint of the stock’s support/resistance zone of 40/50.  Given that we traded Dec, we are also playing for the options structure to decay during the holiday season.