$HD Q3 Earnings Cheat Sheet and Trade Update

by Enis November 17, 2014 1:11 pm • Commentary

Event:  HD reports its fiscal Q3 earnings tomorrow morning before the open.  The options market is implying about a 3.25% one day move, which is in line with both the 4 and 8 quarter average of about 3.25%.

Sentiment:  Wall Street analysts are somewhat positive on the stock, with 20 buys, 13 holds, and only 1 sell, though the average 12 month price target is only around $99.50.  HD is only up 20% year-to-date, one of the mega cap leaders in 2014.  Short interest is negligible at around 1% of the float.

Options Open Interest:  Total open interest is skewed towards puts by a ratio of 1.35 to 1.  The recent 1 month volume has also favored puts by a ratio of 1.2 to 1, even as HD has made another new all-time high.

For a $133 billion market cap stock, HD’s options volumes are quite tame.  The Nov22nd 97.50 calls have over 9k of open interest, which is the most of any near-term strike.  The bulk of the put open interest is at strikes of $90 or below.

Price Action / Technicals:  HD gapped higher above its 18 month range on its mid-August earnings report, after finding resistance in the $80-$83 area on numerous occasions:

HD weekly chart, courtesy of Bloomberg
HD weekly chart, courtesy of Bloomberg

The daily chart shows more clearly the large unfilled gap from the earnings report that is now about 15% away:

HAL daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg
HAL daily chart, 50 day ma in pink, 200 day ma in yellow, courtesy of Bloomberg

The stock was one of the first mega caps to hit a new high after the October V-bottom.  Since then, the $95 level has acted as support (with the rising 50 day moving average nearly there now as well), while $100 is the obvious psychological level to watch on the upside.

Volatility:  HD 30 day implied volatility is at the high end of its 2 year range, in line with where implied vol has been prior to recent earnings reports:

HD 30 day implied volatility, courtesy of Bloomberg
HD 30 day implied volatility, courtesy of Bloomberg

Since HD is one of the few retailers for whom the holiday season is actually a quiet period compared to the spring and summer housing-products high season, options traders have priced in a relatively quiet end of the year after the earnings event in HD.

Our View:    We have an existing put spread in HD that we initiated in late October when $HD was near $95, with the following rationale:

We view the likelihood of a 5-10% move lower in HD as greater than a 5-10% move higher  over the next 4 months.  HD traded as low as $86.50 just last week, and we see the risk of a similar swoon at some point in the next 4 months as underpriced by the options market at the moment.  Given HD’s breakout above $83 in August, we don’t anticipate much more downside below the $85 level, which is why we chose the 95/85 put spread as our structure.

We paid $3.05 for the Feb 95/85 put spread, and that put spread is now worth around $1.80.  Our original thesis rested on the fact that HD implied volatility was relatively cheap going out to February in an environment where realized volatility had picked up.

At this point, the trade is a loser, but there are still more than 3 months until February expiration.  Fundamental expectations are also quite high, with 20-25% year-over-year EPS growth expected over the next 2 quarters, and that follows a blowout Q2 earnings report.  With that in mind, we like the idea of holding on to the trade for now, but taking it off on the first significant move lower in HD between now and February.