Anatomy of a Trade – Mind the $GPS

by CC February 27, 2015 1:21 pm • Commentary

Gap stores reported Q4 results last night that beat on earnings but dissapointed on guidance:

Gap Inc.’s fourth-quarter profits barely topped analyst expectations after getting a big lift from its discount Old Navy Brand. The results set things up well for new CEO Art Peck, who took the helm on Feb. 1. “I am bullish on where we are overall as a company,” Peck told investors on a conference call, as reported by Bloomberg. “The consistency of performance that we’ve seen with Old Navy — really premised on the back of season-after-season good product that is on-trend and on-brand — gives me a good deal of confidence.”

The stock is higher today and we got a question from a subscriber who did the bullish call fly we highlighted:

Quick question about the GPS trade from last night – I put on the bullish trade that Dan laid out and was very happy that the stock went up. However, the options haven’t gone up as much as I thought from what was laid out in the trade analysis. Is this a time thing? I know there are a lot of moving parts but I feel I got the trade right and am not sure why it isn’t up more. Don’t get me wrong – I’m not complaining I just want to make sure I manage the trade correctly and not see the profit vanish. Thanks again!

So the short answer to the question is that the fly structure takes some time to realize it’s full profitability. The reason for this is similar to how a call spread doesn’t realize its full gains immediately but it’s exacerbated by the 2x short call guts of the fly.

Let’s recap the structure. When the stock was 40.20 we said our preferred bullish structure would be:

GPS March 40/42.50/45 call butterfly for .75

-Long 1 March 40 call

-Short 2 Match 42.50 calls

-Long 1 March 45 calls

With the stock now at 41.50 (up 1.30 from entry) the fly is worth about a dollar, so a nice overnight gain but not nearly its full potential. What’s happening here is that although implied vol in March came in as expected there’s still a few weeks of time to go, and that particularly affects those 42.50 short calls. But the great thing is time really is on the side of the person that is long this fly.

The intrinsic value of that structure with the stock at 41.50 is 1.50 (41.50-40.00). And its max potential is to be worth up to 2.50 if the stock were to pin the 42.50 strike on March expiration. So what that allows is for a lot of patience to try to squeeze out profits on a move higher while knowing that small moves lower or flat-lining sideways in the stock means holding on to the current profits or even making more respectively. That process is not massive at the moment, but it will start to pick up steam in the next week or so.

To be nerdier about it, currently the structure has a theta of -1, meaning every day it gains a penny in value if all other things are left the same (stock price, implied vol etc.) But that 1 penny increases each day exponentially. So by Monday it will be closer to 2 pennies a day. And a week from now could be closer to 5 cents a day, etc.

But you can’t just ignore the stock price obviously. The deltas of the trade are still its biggest factor but amazingly they aren’t massive despite the trade being 1.50 in the money. The deltas currently are +15, so a move a dollar higher or lower means gains or losses of .15 (to keep it simple, it’s actually more in reality because of gamma but that’s another discussion). This too will change exponentially as we approach March expiration. Those 15 deltas will be 20 in a few days. And 50 at some point in the next 2 weeks before closing at 100 deltas if the stock is in the same spot (or zero if the stock is below $40 or above $45).

So for now I’d be using two levels below to determine whether I stayed in this trade. The first is basically right below where the stock is trading and that is the 50 day moving average of 41.40. If the stock continues to hold above that this structure is in great shape. If it broke below that I’d probably just keep that intrinsic/extrinsic value in mind. At $41 on expiration this thing is still worth $1 so there’s some room (not a ton, but room) to let it breathe a little. But you probably don’t want to wait around if the stock shows that the opening gap this morning was all the stock had and if it fails at the 50 day moving average I’d just take the money and run.



Gap Stores (GPS) reports their Q4 results tonight after the close, the options market is implying a one day move* of about 4.3% which is rich to the 4 qtr avg move of 2.5% and the 4 qtr avg of about 2%.

* With the stock at $40 the Feb 27th weekly (tomorrow expiration) 40 straddle (the call premium + the put premium) is offered at about 1.75, if you bought that you would need a move above $41.75 or below $38.25 to break-even on tomorrow’s close, or about 4.3%.

It is important to note that back in October the company announced the abrupt departure of their long time CEO, which caused a 12.5% one day decline in the shares, that was also the result of disappointing back to school same store sales.  The new CEO took over on Feb 1st, immediately issuing a same store sales miss for January, but raised the full year profit outlook on what looks like a lower tax rate.

So for you traders out there, the stock is going to trade on forward guidance.  The new CEO, Art Peck has been with GPS for ten years, so it’s less likely that he would take a page out of the normal “incoming CEO playbook” and lower the bar to set the stage of a series of beats out of the gate. The reason is a downgrade of guidance would also be a reflection on his tenure as the President of Growth and Innovation for the last 3 years.

Price Action / Technicals:  The stock has been an under-performer for the better part of the last two years, down 5% on the year, and trading within a fairly wide range between $36 and $44 for the better part of this period, with the stock now in the dead middle:

GPS 2yr chart from Bloomberg
GPS 2yr chart from Bloomberg

Implied volatility is not extraordinarily high going in:

Screen Shot 2015-02-26 at 10.36.37 AM
2 yr IV30 from LiveVol Pro

But March vol at about 32 right now will likely be in the mid to low 20’s following. That means a likely .50 decrease in the March at-the-money straddle overnight given no movement in the stock.

Teen apparel stocks have been a bit of a mixed bag of late with ANF in a death spiral and a bit of a resurgence by URBN. GPS is most definitely in a transitional period with a new CEO, with high expectations for a re-acceleration of growth.

Potential trades depending on your directional inclination:

Bullish:  For those who think management guides in line or higher and the stock retraces a bit of the recent decline, then the GPS ($40.22) March 40/42.50/45 call butterfly for .75  looks like a better own than stock. The spread is 22 cents in the money,  has gains of up to 1.75 between 40.75 and 44.25 with a max gain of 1.75 at 42.50.  Max losses of 75 cents below 40 and above 45.



Bearish:  If you are of the mindset that the new CEO lowers the bar going forward and the stock has risk back to the mid to high $30s, then I would look at the weeklies to merely isolate tonight’s earnings event.  With the stock at $40.30, the Feb27th weekly 40/38 put spread for 60 cents looks decent, break-even at 39.40, with max gain of 1.40 at 38 or lower.

The stock is right in the middle of the recent range, and taking a guess on guidance given the recent turn of events at the company does not seem like a great use of risk capital, but the set up is interesting for those who have conviction.