Into potentially volatile events like earnings, specifically in stocks with high implied moves, and a history of post earnings movement, we like to offer what we deem to be dollar cheap hedges for those who are already long, or defined risk stock alternatives for those looking to gain long exposure, with defined risk. Yesterday we did just that in Salesforce (CRM) prior to their Q3 results. Here were the two trade ideas and their rationale:
So What’s the Trade?
If you are long, or thinking about getting long, we think stock alternatives or hedges make sense.
Hedge vs long stock:
CRM ($76.85) Buy the November 72.5/66 put spread for 1.00
Rationale – this trade serves as breakdown protection if the stock falls below support. It costs a little more than 1% of the underlying and for those that want this as a holding long term, this type of event protection is a reasonably small price to pay to reduce risk.
Stock Alternative/ Replacement:
CRM ($76.85) Buy the December 75/85/95 call fly for 2.75
Rationale – Reducing risk to 2.75 and targeting $85 on an upside breakout. This has the potential to be worth 10 at $85 on December expiration. Not all of those gains will be realized immediately after the report, but if the stock is higher, vol will be substantially lower and this will be profitable (as long as the stock is above 77.75) and the fly will approach 100 deltas over time. A move higher than 85 and profits begin to trail off but that is the price paid for having only 2.75 in risk if the stock tanks.
Both trades did what they were supposed to do. With the stock higher the hedge is worthless, but it only cost $1 vs the stock being up 4.00. And the stock alternative that cost 2.75 before earnings now is worth 4.25 (but intrinsically worth 6.20 with the potential to be worth up $10 if the stock continues higher towards $85 before December expiration). Both these trades were a great way to define risk into the event.
Obviously if you were long the stock and put the hedge on there’s nothing to be done and it can expire worthless. The fly is in play until December and thinking about trade management should start now. With the stock at 81.25 this fly is about 23 deltas. So it’s bullish here but still much more reduced risk than long stock. And the fact that intrinsically it is worth a lot more than mark to market allows you to be patient. But a stop on the downside if the stock is unable to hold $80 makes sense. On the upside you can be very patient with the ideal scenario being a slow creep up to $85 in the next few weeks.