Prior to Lennar’s (LEN) Q4 results in mid December we placed a defined risk bearish bet looking for a pullback to the September lows with a possible breakdown to $44. Here was the initial 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.
Immediately following the earnings we saw the stock lower (and gains on the trade) but it rebounded into year end with the broader market and our trade became a loser. We updated the trade on Dec 28th when it was a loser and said this at the time:
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).
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.
So What Now?
The broad selloff to start 2016 has this trade back in a good spot. With LEN now 46.75 the trade is worth about 2x what we paid. So as far as management we need to keep a close eye on it as it it short nearly 40 deltas. A move higher from here back towards 48 and the trade hat the potential to become a total loss. Here and lower and it’s likely a double or more. So we’ll move down our mental stop to new breakeven levels on the trade. Since we paid 70 cents that means we don’t want to see the stock higher than 47.30. At that point it goes from in the money to out of the money intrinsically and we could stop ourselves out at that point for a small gain. On the flipside, any move lower from here has great potential. At $44 the trade is worth $4, and even at $46 (the lows from yesterday) it’s worth $2.
So from a risk reward standpoint it makes sense to give the stock some time to see if $46 holds while keeping a stop above here to make sure the trade doesn’t become a loser again.