New Trade $IBM – The Blue Lagoon

by Enis January 21, 2014 12:42 pm • Commentary

We discussed the fundamental, technical, and volatility situation in IBM ahead of earnings in this morning’s preview (included below).  We debated potential structures (including the right strikes, the right expiries, and the strategy for taking a potential loss or a profit after the event), and decided on the following trade:  

TRADE: Bought the IBM ($187.85) Feb22nd 195/185/175 Put Butterfly for $3.00

– Bought 1 Feb22nd 195 Put for 9.85

– Sold 2 Feb22nd 185 Puts at $4.10 each ($8.20 total)

– Bought 1 Feb22nd 175 Put for $1.35

Breakevens on Feb22nd expiration:

Profits: btwn 178 and 192 make up to 7, with max gain of 7 at 185

Losses: losses of up to 3 btwn 175 & 178 and btwn 192 & 195 with max loss of 3 below 175 or above 195.

Trade Rationale:

The rationale is mostly detailed in the conclusion from our preview.  The stock has been in the 175-195 range for the most part of the past 5 months, so we like the midpoint for the structure around 185.  Given the rally into earnings, we gave the structure a slight negative bias.



$IBM Q4 Earnings Preview, January 21, 2014

Event:  IBM reports its Q4 earnings tonight after the close.  The options market is implying about a 4.25% one day move, which is below both the 4 qtr avg of about 5.25% and the 8 qtr avg of about 4.75%.

Sentiment:  Wall Street analysts are not positive on the stock, with 9 Buys, 21 Holds and 2 Sells, with an average 12 month price target of around $195.50.  The stock’s short interest stands at 2.4% of its float, which is actually its highest level in 5 years, though still relatively low overall.  The stock is flat over the past 2 years, which is major underperformance relative to the rest of the market.

Options Open Interest:  Open interest is slightly skewed towards calls, by a ratio of 1.15 to 1. Recent activity has been skewed towards calls as well, with a one month average call to put ratio of 1.2 to 1.  Here are the strikes with over 5k of open interest:

-Feb22nd 170 puts

-Feb22nd 175 puts

-Feb 22nd 185 calls

-Feb22nd 190 calls

-Mar 200 calls

-Jan15 150 puts

-Jan15 250 calls

Price Action / Technicals:  Dan laid out the technical situation in IBM in a CotD post on Friday:

IBM has had a stealthy rally in the last month, up 10% in almost a straight line since mid December,  a classic “Dog of the Dow” move.  The one year chart below actually looks quite encouraging, making what some technicians might call a double bottom (circled green):

IBM 1 yr chart from Bloomberg

IBM 1 yr chart from Bloomberg

While the double bottom clearly drew in buyers, the stock’s brief engagement with it’s 200 day moving average (yellow line) might have drawn out sellers as the company is set to report Q4 earnings next week on Tuesday after the close.

Fundamentals/Valuation:  We have written in detail about the low quality of IBM’s earnings growth after its poor result last quarter.  Here is what I said about IBM’s earnings growth in a Name That Trade post 2 weeks ago:

Following IBM’s weak earnings report in mid-October, we highlighted some of the longer-term fundamental concerns for the company in a Macro Wrap post, most notably IBM’s financial engineering to continue to grow earnings despite flat sales for the past 5 years.

IBM reports earnings in 2 weeks.  Expectations are for 11% year-over-year earnings growth on a 4% year-over-year decline in sales (there’s that theme again).  Now, here’s the thing about IBM’s valuation – it all depends on how you measure it.

On a P/E valuation basis, the stock looks cheap vs. the past 10 years:

Trailing 12 month P/E, Courtesy of Bloomberg

IBM Trailing 12 month P/E, Courtesy of Bloomberg

However, on a Price to Free Cash Flow basis, the stock is near the high end of its 10 year range:

IBM stock price to free cash flow, Courtesy of Bloomberg

IBM stock price to free cash flow, Courtesy of Bloomberg

Moreover, the inability to grow sales is a concern for any large tech company, especially since the tech industry backdrop is so frequently changing.

Volatility:  IBM has been trading in the 170-216 range for the past 2 years.  Given that rangebound technical situation and the low level of realized volatility for IBM outside of earnings events, and it’s not a surprise to see implied vol only in the low 20′s ahead of earnings:

30 day implied vol, Courtesy of Bloomberg

30 day implied vol, Courtesy of Bloomberg

Last January, implied vol fell all the way down to 11.5 after earnings, quite a drop.  We might consider some short vol strategies in IBM ahead of the event.

Our View:  When we laid out the IBM put butterfly idea in the Name That Trade post from January 7th, we had laid out the following rationale:

This trade structure goes out to the month that follows earnings, but it is profitable if the stock closes between the 192 and 178 range on Feb expiry, which is a scenario that I view as decent probability given the stock situation we’ve outlined above.  If IBM goes lower from here, which we think is more likely than a rally through 192, we don’t think it will make new lows in the near term, as there seem to be buyers below.  A move higher in the stock is likely to be contained by the significant overhead supply built up over the past 2 years.  We might look to put on this trade closer to earnings in 2 weeks, since the trade is unlikely to appreciate much before then, and as stated above, would like to time the 192 level and higher vol as best as possible.

With the stock indicated around 190.60 this morning (right around its 200 day ma), and the Feb22nd 195/185/175 put fly trading between 2.75 and 3.00, we might put this trade on today to take advantage of elevated implied vol, a stock price right at resistance, and a long-term fundamental situation that is stagnant at best.

The one risk is that expectations are low enough that IBM rallies strongly after the earnings report.  The stock has had a tendency to move alternately higher and lower on subsequent reports over the past few years.  However, since the stock has rallied 10% in the last 6 weeks into the report, we feel that a good bit of enthusiasm is built in to the stock price here.

If we pull the trigger, we will of course post during the trading session.