Skullcandy Options Strategies For The Cautiously Bullish

Nov.26.12 | About: Skullcandy (SKUL)

Unless there's something short investors know about Skullcandy (NASDAQ:SKUL) that the rest of the market doesn't, it seems as though there's a huge discrepancy between what their stock is worth and how it's priced. There have been several articles (including one of my own) about the undervalued company and the possibility of a short squeeze. I even reaffirmed my bullish stance on the stock at the new lows we've seen in the past week. Still, it seems some investors are cautious about buying in just in case the shorts are correct. However, I'm here to tell you that it's possible to limit your losses in the event that Skullcandy plummets but invest with a bullish outlook. I've setup two options strategies that I feel are a good starting point for investors to customize their risk-reward trade offs for this stock.

Call Backspread

Our first spread is simple with only two options legs and no stock. The first leg is a short call contract for a strike price of $5 for the June 22 2013 expiry. At the time of writing, this contract sold for $2.70 per share, or $270 per contract. The second leg of this spread is 2 long call contracts with the same expiry and a strike price of $8, which were priced at $1.25 per share or $125 per contract at the time of writing. Our total premium earned is $20 per spread which should cover brokerage fees with most firms. Here's a breakdown of the legs:

Expiry

Strike

Put/Call

Quantity

Cost/Premium

Long/Short

June 22 2013

$5

Call

1

$270

Short

June 22 2013

$8

Call

2

$125

Long

Click to enlarge

The maximum loss for this spread occurs if the price of Skullcandy happens to be $8--exactly where it is now--in June of 2013. Should that happen, we would lose $300 to provide 100 shares to cover the short call contract. When we add in the premium of $20 we collected, our maximum loss ends up being $280 per spread. Losses occur as long as the price remains between $5.21 and $10.80. Should Skullcandy stock gain value, the profit potential is unlimited above $10.80. Below $5.21, we collect some or all of the premium but no other profits will occur.

click to enlarge images

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This strategy is best for investors who are bullish on Skullcandy but do not want their funds tied up in the stock just yet. It also works to limit losses to a specific amount and higher volatility typically helps your position.

Married Put

Our second spread is contains two legs, however one of them is stock. We couple a long position of 100 shares of Skullcandy (priced at $8.01 at the time of writing) with a long put contract to protect us on the downside. The strike price for the put contract is $7.50 and the expiry is June 22 2013. As of the time of writing, this contract costs $60 per contract or $0.60 per share. Our total initial investment is $861 per spread. Here's the chart:

Expiry

Strike

Put/Call

Quantity

Cost/Premium

Long/Short

Stock

Stock

100

$801

Long

June 22 20113

$7.50

Put

1

$60

Long

Click to enlarge

For this spread, the maximum loss is $0.51 per share or $51.00 per spread. Profits are unlimited on the upside as long as the price of Skullcandy moves past $8.61 ($0.60 to cover the cost of the put contract). This spread is perfect for investors who are bullish on Skullcandy and don't mind putting in the funds to buy the stock outright but would like downside protection.

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Which spread is right for you?

Skullcandy is a stock that has been beat up by short investors since its debut. Recently it's seen all time lows which makes it an awesome value for investors who are bullish and believe in the company's business model. At the same time, it's important to weigh the risks and see what's right for you. Options provide a way for investors to make large profits with smaller initial investments but they come with their own set of risks. It's important to consider your broker's margin requirements for options and factor in brokerage costs for all spreads.

All of the graphs above were created using the Optionistics.

Disclosure: I am long SKUL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.