An allure of the option market is the ability to craft trades with quantifiable, limited downside risk and large potential gains. Whether we're purchasing one contract or multiple positions, option markets offer great flexibility.
As Crocs's (CROX) earnings announcement approaches, I will use such flexibility to our advantage. In my weekly newsletter EPIC Insights, I have recommended a long position in CROX that has delivered an 11% gain. The stock has been following a steady uptrend, and I continue to believe it will trade to $10. However, the looming earnings announcement has me concerned.
Looking at the past 11 quarters reveals that CROX tends to trade wildly after earnings are announced. With an average swing of 25% and a minimum change of 10%, we should expect CROX to be volatile. The question, which I cannot answer, is which direction the shares will move.
If we assume the 25% average change will occur, we could see the stock at either $9.80 (close to my price target) or $5.88 (would create steep losses). I am not interested in such linear gambles. Instead, I will allow options to offer me a trade with strong upside potential and limited risk.
In this case, my focus is the CROX March 8 calls, which cost $.50. Buying these calls will deliver a gain of $1.30 if the upside target is met, but only a loss of $0.50 if the shares move lower. This potential gain is 2.6 times greater than the potential loss-the type of probability I like.
Using the risk versus return tradeoff, I recommend selling the current position in CROX and replacing it with CROX March 8 calls as this week's option trade. Doing so maintains the upside gain and limits the downside risk.