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Overview

The recent precipitous decline in shares of Skullcandy, Inc. (SKUL) has created an intriguing opportunity for bullish investors. We will focus in this writing on the use of options to profit from what I believe will prove to be strong bullish price action in 2013. As always, perform your own due diligence prior to taking any positions.

From the most recent 10-Q, Skullcandy, Inc., is a global designer, marketer and distributor of performance audio and gaming headphones and other accessory related products under the Skullcandy, Astro Gaming and 2XL by Skullcandy brands.

SKUL went public last July for $20.00 per share and as of this writing, is trading at about $8.50, off of the recent low at $7.70. This despite 5 out of 6 quarters as a public company of earnings beats and 20%+ revenue growth. In addition, the company is trading for well under two times book value, which is hardly considered expensive for a growing small cap. In addition, short interest is cresting 50% of the float, which means SKUL could be ripe for a short squeeze rally if bullish price action presents itself. While there have been some troubling developments recently, including a lengthening cash conversion cycle and inventory builds, the Skullcandy brand remains strong and the market for stylish, personalized, affordable headphones is not going away. While the fundamental outlook for SKUL remains strong, a full fundamental evaluation is outside the scope of this article. Instead, we will focus on what a bullish investor can do to get some exposure to bullish price action with options.

Scenario 1

Buy to Open 1 June 13 6 Put for $1.05 (Bid/Ask midpoint at time of writing)

Sell to Open 1 June 13 12 Put for $5.50 (Bid/Ask midpoint at time of writing)

If you put this trade on in an IRA (as I have), you will need a total of $1,200 of free cash for the short put, $105 to purchase the long put and whatever fees your brokerage charges. This trade has a breakeven point (excluding commissions) of $7.55 per share on June 13 expiration. Max loss is $1.55 per spread if shares trade at $6.00 and below on June 13 expiration and max profit is $4.45 per spread on June 13 expiration if shares are $12.00 or above. The profit and loss graph for this trade is presented below.

(click to enlarge)

This trade presents a potential return of 34% on capital in a little over 7 months at the maximum and a potential loss of about 12% on capital. Of course, if you are putting this trade on with margin on the short put, you will need considerably less capital tied up and therefore, returns and losses on capital will be magnified.

This trade also sells about $1.00 more option premium than purchased so Theta will work in your favor as well.

Scenario 2

Buy to Open 1 June 13 6 Put for $1.05 (Bid/Ask midpoint at time of writing)

Sell to Open 1 June 13 12 Put for $5.50 (Bid/Ask midpoint at time of writing)

Buy to Open 1 June 13 10 Call for $0.80 (Bid/Ask midpoint at time of writing)

This is the same trade except for the long 10 call. This is for more aggressively bullish traders who think there is less downside risk to the current price. This trade has a breakeven point (again, excluding commissions) of $8.35. Max loss is $2.35 per spread if shares trade at $6.00 and below on June 13 expiration and max profit is $5.65 at $12.00 and potentially unlimited at $12.00 or above. The profit and loss graph for this trade is presented below.

(click to enlarge)

This trade presents a potentially unlimited return on capital and a potential loss of about 18% if put on with no margin. You should still end up with a small credit in your account based on the prices quoted but Theta isn't a tailwind for this trade's profitability the way it is without the long call. You must trade the decay for the potential of unlimited profits on the high end.

Conclusion

If you agree that Skullcandy's selloff has been too severe, we have shown a couple of ways to profit from potential share appreciation in 2013.

One trade is for the more conservative options trader and one is for the more aggressively bullish trader. I believe Skullcandy's business is significantly undervalued at $8.50 a share and have shown a couple of medium term options trades that can capitalize on share price appreciation without the risk of owning shares outright. Of course, one could also use the structures presented but adjust the strike prices to better suit your outlook on the stock and risk tolerances.

Source: Bullish Options Strategies For Skullcandy