Update – Home Depot (HD) May Call Fly

by CC May 3, 2017 1:36 pm • Trade Updates

In late February, we looked at Home Depot (HD) shortly after its earnings. At the time it had established new highs and started what would become a fairly long consolidation at those highs. At the time we detailed a stock alternative and a hedge in case that consolidation broke. (A few weeks later, with the stock a bit higher we checked back in on the trades to determine which performed better (read that here)).

With the stock now breaking out from that consolidation and now at the midpoint of our stock alternative, I wanted to check in on that trade and see what needs to be done from a management standpoint. To recap, here was the trade, from February 28th:

HD ($145.25) Buy the May 145 / 155 / 165 call butterfly for $2.50
  • Buy to open 1 May 145 call for 4.30
  • Sell to open 2 May 155 calls at 95 cents each (1.90 total)
  • Buy to open 1 May 165 calls for 10 cents

The idea here was to define risk to just 2.50, while targeting a realistic move higher. With the stock 155 this trade is worth about 4.75, which means it’s a winner and that sure beats a sharp stick in the eye.

But why isn’t it more profitable at this point?

The issue is that earnings are May 16th, which was part of the premise, to begin with, defining risk in a month that captured the event itself. The “problem” is that the stock already moved to the target, before earnings. And the reason that matters is the 155 calls that are short (times 2) in the butterfly are pumped. They are the at-the-money straddle indicating the implied move for the May 16th earnings.

Now remember what I mean when I say they are “pumped” doesn’t necessarily mean they have seen their implied volatility increase since the initial trade. In this case it means HD implied vol hasn’t declined with the rest of the market due to its impending report. Here’s the chart of 30 day implied vol:

That rising vol into the earnings report is the May options becoming more heavily weighted in the HV30 formula (for more on how that works read here)

So back to the trade, intrinsically it’s worth $10! But mark to market, it’s only worth 4.75. That means there is 5.25 in short extrinsic premium that has yet to be realized. Think of it this way, if the stock were to be in this exact spot on expiration, the mark to market of 4.75 on this trade would be worth $10.

So what to do? The implied move into the event is about $6 in either direction. So I would approach trade management dependent on what the goal was. If the goal is simply a trade to make money, I’d stay with it and re-assess right before the 16th, the breakevens on the trade are so far away that there’s really no reason to take it off before then. And there’s a strong argument for holding it through the event itself as the risk/reward at that point will be pretty high.

For those who want exposure bullish exposure to HD into the event, this is no longer the greatest trade, as moves to the upside won’t really be captured other than that extrinsic premium coming in. In other words, this trade maxes out at 10 if the stock is right here on expiration. It can only be worth less than 10 if the stock is higher than here.

So for those looking to ride HD higher and higher it may make sense to adjust this fly higher, rolling to the 150/160/170 call fly perhaps. That costs around $3. That means total risk is now down to 1.75 from the original trade with the chance to make up to 8.25 on a continuation of the move.