Trading Home Depot's Upcoming Earnings Using Options

| About: Home Depot, (HD)

Since the beginning of the year shares of Home Depot (NYSE:HD) have increased $9.75 and have been a consistent performer to the upside. Home Depot is currently at levels not seen since 2002, and with these recent highs and an upcoming earnings report investors may ponder how to trade Home Depot.

When considering using options there are many different ways to trade companies that are heading into earnings. One way I like to trade options are buying deep-in-the-money calls on companies that have a history of having a run-up going into earnings. Directional strategies can be tricky at times, but if the stock can be bought at an attractive technical level and the overall market is poised to go higher, this can be successful. For an example, please click here.

Besides using directional strategies, another weapon that option traders have to use are non-directional strategies. Three of the most commonly used strategies are reverse iron condors, straddles and strangles. When taking a look at a chart of Home Depot, investors will notice there hasn't been many pullback opportunities to buy on the dips and be able to cash out before earnings. From a technical level, Home Depot hasn't fell to the lower Bollinger Band since October. While this is a bullish sign for Home Depot in the long run, for investors who may worry about whether or not Home Depot can keep up its amazing run, using a non-directional strategy is the way to go.

Chart forThe Home Depot, Inc.

Home Depot is a big-box home retail improvement center and offers an array of products/services for the do-it-yourself customer and contractors. Home Depot has benefited from improvements in the housing sector in new and existing homes being purchased. Even if there is worsening housing data moving forward, Home Depot is a strong play for existing homeowners who will always have to do repairs to their house. Home Depot pulled off the blanket that was placed on anything related to housing in October 2011 as investors realized that people were going to continue to make improvements to their their houses and wait out the slump in the housing market.

Home Depot's main competitor is Lowe's, but it also competes with Ace Hardware, True Value and Best Buy (NYSE:BBY). In a way, Home Depot can be described as the Wal-Mart of home improvement retailing, and Home Depot is poised to continue running higher. During Home Depot's last quarter the company delivered a positive earnings surprise of 0.50 per share vs. the consensus estimate of 0.42 per share. During the last quarter, Home Depot was able to grow net earnings and gross profit from the previous quarter. Home Depot is also seeing the benefits of an improving consumer, since Home Depot was able to increase the number of ticket transactions and average ticket vs. previous quarters. If Home Depot can continue to show positive numbers, then holding on to Home Depot should continue to pay off in the long run.

For investors who are looking to make a trade on Home Depot and want the ability to profit no matter what direction it goes in, than considering a non-directional strategy is the way to go. Home Depot reports earnings on May 15, 2012, and has moved over 5% the last two quarters:

  • Q3 earnings reported on Nov. 15, 2011. Nov. 1, 2011, close at $35.54 to Nov. 14th close at $38.25 = $2.71, or 7.6% move right before earnings.
  • Q4 earnings reported on Feb. 21, 2012. Feb. 1, 2012, close at $44.97 to Feb. 17 close at $46.71 = $2.24, or a little over 5%.

One non-directional strategy to consider for Home Depot's upcoming earnings is a strangle. A strangle is the purchase of a call and a put that are slightly out of the money. Even though investors could have just traded Home Depot to the upside, a strangle makes investors profitable when the price of the stock trades above or below the put/call breakeven point.

The strangle will be a net debit transaction given that investors are paying for equal number of calls and puts. Earnings can sometimes be a tough event to trade around, and by playing both sides of the fence investors can limit losses and profit off of a rise in implied volatility in the stock. Here is a strangle trade to consider when trading Home Depot's upcoming earnings:

  • Buy May 19 52.50 call = 0.72 (0.72 x 100 = $72)
  • Buy May 19 50.00 put = 0.40 (0.40 x 100 = $40)
  • Breakeven Points = 52.5 + 0.70 = 53.20 on the call side and 50 - 0.40 = 49.60 on the put side
  • Total Cost = $112 per strangle per 1:1 ratio of calls and puts.

Note: Investors should try to get into this trade for under 1.00 per strangle.

Home Depot closed on April 26, 2012, at $51.87 and is right in between the strikes of the calls and the puts. When selecting a strangle, investors want to select strikes as close to the actual price as possible. At the current price, Home Depot needs to move 2.5% to the upside to reach the breakeven of the calls or move 4.4% to the downside for the strangle to profit.

In conclusion, I will be looking to put on this trade within the next couple of days. If investors believe that Home Depot will rise in implied volatility before earnings, this trade can be profitable -- if Home Depot can make a significant move in either direction up to earnings. Investors may choose to hold on during earnings, but generally if profit can be achieved before earnings, this can be the safe way to go.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I will consider doing this option trade within the next couple of days