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Lululemon reports earnings at 9 a.m. Friday, September 7th, 2012. Long-sided investors in the women's yoga apparel manufacturer are hoping the company reports similar earnings and guidance as one of its competitors, Under Armor (UA). UA announced earnings July 24th, beating analysts' estimates, while raising forward looking guidance. Since announced its earnings, the stock has risen more than 10%.

Short-sided traders call to mind, Nike's (NKE) performance following its most recent earnings announcement. Now, nearly back to even since their June earnings announcement, has had to climb back after a near 15% decline in stock price the day following their announcement.

Looking to the option market for indication of Lulu's movement, we see September weekly options, which expire this Friday, currently trade with an implied volatility of 125%. The implied volatility and option market, prices in an expected move of +/-$6.7, or just under 10% by Friday's close. This option cycle will end the day of the earnings release. September monthly options with 17 days to expiration trade with volatility at under 75%, while October monthly options trade with volatility under 60%. This volatility differential tells us we will see a large expected move following earnings Friday, and a volatility contraction following the announcement. This high front month volatility will allow option traders to take advantage of premium decay and design their strategy around earnings.

The following strategies will allow traders to take advantage of the high implied volatility in Sep1 2012 options with 3 days to expiration.

1. Neutral Strategy-Sell an Iron Condor around the +/- $6.7 expected move.

  • We identify a 2 standard deviation move for by Friday's close to be near a 8.5 point swing. If you expect to trade within the expected move of 6.7 points, you may wish to expand the expected move to 2 standard deviations to give yourself more protection. From 's current price of just over $66, this will present us with price range of $57.5 to $74.5. If you expect to trade within the expected move of 6.7 points, you may wish to expand the expected move to 2 standard deviations to give yourself more protection.
  • Using the above given price range we suggest selling an Iron Condor of Short $57.5 Strike Put, Long $55 Strike Put, Short $75 Call, and Long $80 Call.
  • The total credit from shorting this Iron Condor will be $65/contract.
  • Buying power/margin requirement for this trade will be relatively low, approximately $450 per contract.
  • Max profit will be $65, as long as, trades between $56.85 and $75.65

2. Long Strategy #1 -Sell a Vertical Put Spread

  • Keeping with a low risk strategy, we will utilize the 2 standard deviation used above in the Iron Condor. Simply, we will utilize the put portion of our Iron Condor trade.
  • Short $57.5 Strike Put, and Long $55 Strike Put.
  • The total credit from shorting this vertical spread will be $30 per contract.
  • Buying power/margin requirement will also be low, approximately $230 per contract.
  • Max profit will be $30, as long as, trades above $57.20.
  • This strategy gives a lot of room to the downside, while you can collect the premium from the options which is elevated from the high volatility.

3. Long Strategy #2-Buy a Vertical Call Spread

  • For a $1.45 debit, a trader bullish on earnings can buy a $65 Strike Call and sell a $67.5 Strike Call.
  • This trade will be profitable if trades above $66.45, while profits will diminish as rises above $67.5.
  • Maximum Loss is capped at the debit you pay for this trade, or $1.45 per contract.
  • This strategy will keep our capital requirement low approximately $145 per contact.
  • This bullish strategy can be altered if willing to use more capital, subsequently taking more risk, if one seeks a higher maximum profit, by simply raising the strike price of the call sold from $67.5 to $70. This would cost $260 per contract, while max profit now becomes $240.

4. Short Strategy #1- Following the similar pattern of Strategy 2 we can use the call portion of our Iron Condor Strategy.

  • Short $75 Strike Call and Long $80 Call for a $35 credit per contract.
  • Buying power/margin requirement will be approximately $460 per contract.
  • Max profit will be $350 while needs to trade below $75.35, which five significant room for to trade higher, while you can still benefit from collecting premium from the high volatility of the option market.

5. Short Strategy #2-Buy a Vertical Put Spread

  • For a $1.05 debit, a trader bullish on earnings can Buy a $67.5 Strike Put and Sell a $65 Strike Put.
  • This trade will be profitable if trades below $66.45, while profits will diminish as falls below $65.
  • Maximum Loss is capped at the debit you pay for this trade, or $1.05 per contract.
  • This strategy will keep our capital requirement low approximately $115 per contact.
  • This bearish strategy can be altered if willing to use more capital, subsequently taking more risk, if one seeks a higher maximum profit, by simply lowering the strike price of the put sold from $65 to $62.5. This would cost $185 per contract, while max profit now becomes $260.

Whatever your assumption is, bullish, bearish, or neutral, options can help you define your risk, use less capital than purchasing stock, while taking advantage of higher than normal implied volatility. The option market indicates will have an 84% probability of trading above $57.5 by close of trading Friday and 89% probability of trading below $75. Using the liquid and efficient option market as a gauge of the market you can place your trades with a higher probability of success.

Source: Lululemon Athletica Earnings Plays