Shortly before Lennar (LEN) reported earnings we psoitioned for weakness in the stock with a defined risk put butterfly with good risk/reward (risking .70 with the chance for up to 3.30 in profits) if the stock was lower than 47.30 on January expiration. Here wad the original trade and rationale:
*Trade: LEN ($48.95) Bought Jan 48 / 44 / 40 Put ButterFly for 70 cents
Rationale: Implied vol is only slightly elevated into the event but we still wanted to reduce as much out of the money premium risk as possible in case we’re wrong on initial direction. If we do indeed see a move lower and the fly becomes in the money vol should decrease both because the event has passed but also because of holiday trading. If the stock does move lower, intrinsic gains won’t immediately be realized and patience will be in order. However, with a break-even at 47.30 and a max gain at the 44 strike the trade any move lower and we should be in good shape. The worst scenario is obviously a move higher on the event, and a stock unchanged and we would suffer losses on vol coming in.
LEN stock did drop following earnings (getting below 47 briefly but quickly rebounded and is now slightly higher than our entry. Because of both decay (on the the out of money fly) and the stock being slightly higher this trade is now a loser. So we have to start thinking about trade management.
With the stock at 49.10 the fly is worth about .45 (vs the .70 paid). We only have a few weeks left until expiration so we don’t want this to become a total loss so what we will do is keep a mental stop in the trade both from a stock perspective and a premium lost perspective. If the stock goes higher from here those will coincide and we’ll just take the loss around 50% of what we paid. If the stock goes sideways or even slightly lower but not low enough to bring the 48 strike into play we’ll have to take our losses near 50% all the same (the trade is currently -22 deltas but that approaches the longer the stock stays where it is, all else being equal).
The risk with a trade like this is once you let it get to say .20 or less it’s not worth taking off and you just let it become a lotto ticket. Those lotto tickets generally become worthless so we don’t want to get to that point.
Where we would stick with the trade is if we some some decent selling in the stock into the year end, where the 48 strike becomes realistic. But we’ll have to see that soon or else we get trapped in the lotto ticket scenario we never like to be in into the final weeks before it expires.