In our recent article, Bulking Up for Earnings, A Protected Play for GNC, we presented a protected stock position prior to an upcoming earnings event. Due to the effects of Hurricane Sandy, GNC Holdings Inc. (NYSE:GNC) has postponed its earnings release from Tuesday morning to Thursday morning, November 1st. In that previous article we said that we would present a comparison of the married put setup vs. an in-the-money long strangle position for stocks that have an upcoming earnings event.
If you have been following our posts you have seen a few articles that discuss the married put initial setup following the RadioActive Trading techniques. Many investors have asked: "Why put up all that capital to buy the stock and the protected put? Wouldn't we do better by purchasing an in-the-money long call instead of the underlying stock?"
We have presented several examples of this comparison, but we wanted to share another example as well as show the comparison trade to the GNC Holdings Inc. married put that was already presented.
eBay Inc. (NASDAQ:EBAY) comparison
During a live webinar on October 16th we were asked the question about substituting an in-the-money long call in place of the long stock, effectively creating an in-the-money long strangle. The investor assumed that by putting less money into the trade and using leverage they were bound to have better profits after an earnings event. Long strangle positions, whether using out-of-the-money or in-the-money options, are usually proclaimed as the best options strategies to take advantage of an upcoming earnings event. We took the challenge and identified a married put position that matched our criteria and had an upcoming earnings event. We then identified an the in-the-money long strangle to compare the two positions. On October 17th our Search tool identified this potential married put:
EBAY Married Put 10-17-2012
Buy 100 shares of EBAY @ $48.20
Buy 1 Buy 1 April 50 strike put @ $ 5.40
Total Invested = $53.60
Guaranteed By Put = $50.00
Total At Risk = $ 3.60, or 6.7%
This married put position offers us a single digit risk amount if the stock moves against us, with an unlimited upside if the stock takes off due to a positive earnings event. This setup is preferred to simply buying stock and placing a stop-order as the put option guarantees that our risks will not exceed 6.7% in this case. A stop-order can be violated if there is a large gap down in the stock price. Here is the profit and loss of the EBAY married put position prior to earnings release:
In-the-money long strangle comparison
At the same time an investor could have substituted an in-the-money long call in place of the stock to create an in-the-money long strangle. We compared the married put position above to using a long call that was roughly the same distance in-the-money as the put option that was selected for insurance. This gave us:
EBAY ITM Long Strangle 10-17-2012
Buy 1 April 50 strike Put @$ 5.40
Buy 1 April 46 strike Call @$ 5.70
Total Invested = $11.10
Maximum Risk = $ 7.10, or 64%
Maximum Profit = Infinite
Here is the profit and loss chart of the in-the-money long strangle for EBAY:
The assumed benefits of this position are:
Investor still has infinite upside profit potential
If the stock collapses, the in-the-money long strangle will potentially have a profit as the married put would have a small loss
Only a fraction of the invested capital is required - $1,110.00 for a 1 contract strangle vs. $5,360.00 for the married put position using 100 shares and 1 protective put.
Using leverage always works better
The actual cons of this position are what we have noticed before:
Larger movement is required to realize a profit with the in-the-money long strangle
The monetary amount at risk is always higher ($3.60 per share for the married put compared to $7.10 at risk for the in-the-money long strangle)
This total at risk is 64% of the invested capital. If an investor suffers a 64% loss they will need to nearly triple the remaining capital on the next trade to get back to break even.
Less capital is required, but this also means that the investor has the potential to over trade the leveraged position. This may, and often times does, result in unwanted losses
What happened after earnings?
Ebay Inc. reported earnings at the close of business on October 17th. The morning of October 18th eBay Inc. shares increased. At market close of October 18th, the liquidation values for both positions were:
Closing values for EBAY married put position (10-18-2012):
Sell to close 100 shares EBAY @ -$50.83
Sell 1 April 50 strike put @ -$ 3.90
Total Liquidation Value = $54.73
Liquidation Gain = $54.73 - $53.60 = $1.13 profit, or 2.1%
The RPM could be liquidated for a profit of 2.1% in 1 day. There was an opportunity to cancel the risk on the EBAY position or to cut the risk by more than half using the RadioActive Trading income methods after the earnings event. How did the in-the-money long strangle compare?
Closing values for EBAY in-the-money long strangle position (10-18-2012):
Sell April 50 strike put @ -$ 3.90
Sell April 46 strike call @-$ 7.25
Liquidation Value = $11.15
Liquidation Gain = $11.15 - $11.10 = $0.05, or 0.45%
The in-the-money long strangle produced only a $0.05 gain compared to a gain of $1.13 on the married put position. If earnings had disappointed and the stock had collapsed, the strangle may have shown a profit where the married put would have been in the negative. This of course depends on the amount of the decline.
On Thursday morning we will look to follow up the GNC Holdings Inc. married put position from October 24th, 2012 as listed in the previous article to this in-the-money long strangle that could have been opened on the same day:
GNC Holdings Inc. in-the-money-long strangle, GNC @ $37.98 (10-24-2012):
Buy 1 March 35 Call @$ 5.20
Buy I March 40 Put @ $ 4.90
Total Invested = $10.10
Maximum Risk = $ 5.10, or 50.5%
Maximum Profit = Infinite
Look for our follow up article on these two positions after earnings are released for GNC Holdings Inc. on Thursday morning.
Disclosure: I am long GNC. 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.
Additional disclosure: The married put referenced in the previous article are the prices we were filled on. We do currently have the married put open on GNC Holdings, Inc.