Seeking Alpha

Using Options To Bet Against Volatility In Hewlett-Packard And Research In Motion

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Includes: BB, HPQ, VIXX
by: Vince Martin

On Tuesday I published an article comparing the June collapse of Research in Motion (RIM) to the recent struggles of Hewlett-Packard (NYSE:HPQ). Today we will look at some (relatively) advanced option strategies to play our theses about the short-term movements in the stocks. In summary:

  • HPQ should follow the trajectory of RIMM; after a small "dead cat bounce" this week, volatility will lessen and the stock will drift downward, as traders move on to the next newsworthy stock and buyers have little short-term impetus to move into stock. Instead, they will await progress in the company's turnaround. Indeed, this week's movement -- a small rise on declining volume -- mirrors RIMM's movements following its own earnings trouble.
  • RIMM will drift sideways, as investors have already digested the bad news from earlier this year, and similarly await good news from the company's new initiatives. Despite an 8% rise this week, the stock still remains about a buck below the peak of its late-June bounce.
  • In addition, I expect the VIX to decrease somewhat over the next three months from near-term highs that neared 2008 levels (as has started to happen this week). This should decrease option premiums going forward.

The following chart (also in Tuesday's piece) shows the 60-day movement of HPQ and RIMM through Friday's close:

[Click to enlarge]

RIMM vs HPQ 60-day

We are expecting HPQ to approximate the RIMM chart, as investors move to the sidelines and await news. (A look at RIMM's volumes in the six weeks following earnings shows the same pattern, as volumes decreased tremendously.) RIMM, which as I argued in June, is now a turnaround play, should continue a sideways drift as investors try to evaluate the company's long-term strategy.

When trying to gauge the time frame for our strategies, we should seek catalysts for large movements in the underlying stock. For HP, earnings will not be released again until mid- to late-November. The company's internal review of options for the PC unit is estimated to be completed in 8-12 weeks, giving a target date of roughly mid-October to mid-November. Barring a hiccup in the Autonomy purchase, there seems little else to provide a sharp move in HPQ stock until November at the earliest.

For RIMM, the company releases earnings on September 15th. With much of the company's struggles priced in via a 60% decline, and little buzz about the company's products from the first half of the year, it seems unlikely that the company's fiscal second quarter earnings will have the same effect as in prior quarters (when the stock lost 11.2% and 21.4% after the March and June earnings, respectively.) Sales data on the company's recently released and much anticipated Bold and Torch phones, running on OS 7 may provide some ammunition for bulls, with yet another quarter of missed guidance providing downside risk. The most promised catalyst for RIM's rebound -- the long-awaited "superphones", running on the company's QNX operating system -- will not be released until 2012, and even if successful will not affect earnings until the middle of next year.

The elephant in the room for traders betting against volatility in both stocks is the possibility of an acquisition, of course. I discount those rumors greatly -- RIMM co-CEO's Balsillie and Lazaridis seem hardly eager to sell their baby, while HP CEO Apotheker would have a difficult time selling shareholders on a $35/share offer (a nearly 40% premium to Wednesday's close) given that the company traded at $50 per share just six months ago.

As such, we expect limited volatility in the underlying stocks of both HPQ and RIMM. Here are some ways to play this prediction in each stock (option prices are from market close Wednesday):

HPQ

1. Bear Call Spread

In a bear call spread, we simply sell an in-the-money call, while buying an out-of-the-money call as protection should the stock break out. Our risk is capped to the difference between the strike prices, minus the net premium received on the trade. Since it is a capped-risk trade, it can be done in a cash account; most brokerages require that you have cash to cover the risk capital.

For a short-term trade, we will sell the October 25 call for $196, and buy the October 28 call for $79. Our premium received -- and maximum profit -- is $117. Our breakeven occurs is HPQ trades over $26.17, with maximum loss of $183 occurring if HPQ breaches $28.00 a share.

There are a wealth of different strategies using spreads: bearish or bullish (bulls would simply reverse the trade and buy the 25, while selling the 28), using calls or puts. Because our losses are capped, they mitigate some of the risks associated with shorting a stock or even buying out-of-the-money puts. In addition, they provide a way to bet against volatility and in a preferred direction.

The next two trades are neutral in direction:

2. Short Straddle

In a short straddle, we sell both a call and a put at the same strike price, in the same month. Please note that this is a risky strategy, as our returns are capped (at the total of the premiums received), while our losses are unlimited. We profit if the stock remains range-bound between the strike plus or minus premium received. Should the stock move sharply, we are liable for losses -- in either direction -- beyond those break-even points. Again, this is a risky strategy requiring a margin account.

For HPQ, we would try and sell short-term volatility, with a strike expiring before potential catalysts such as earnings and results of the PC unit review, by selling a short-term straddle. At the October 25 strike, we are bid a total of $3.80 per share for our straddle. Our maximum gain per contract is $380, achieved should the stock close exactly at $25.00 on October 21st, a small drop from Wednesday's close . Our break-even points are $21.20 on the downside and $28.80 on the high side, requiring a 15.9% drop or a 14.2% gain. Investors willing to add risk to the trade (and with the stomach to handle two earnings reports, most likely) can look at the February 25 straddle, bid at $6.15. Break-even is $18.85, and $31.15, respectively, requiring a 24.3% loss or a 27% gain to lose profit. Bears or bulls can also adjust the strike price, adjusting our profitable range, based on their expectations for the stock.

3. Long Call Butterfly

This is a safer, but more complicated, way to sell volatility in HPQ. Commissions will likely come into play here, as the strategy requires three trades: long 1 in-the-money call, short 2 at-the-money calls, and long 1 out-of-the-money call. Our loss here is limited to the net price paid for the trade; our maximum gain equals the difference in strike price minus the net price for the trade. (This discounts commissions, which can have a substantial impact, depending on your broker.)

For October, we will create a long call butterfly by buying the October 22 call, asked at $405; selling 2 October 25 calls, for a total of $392; and buying the October 28 call for $79. Our net debit -- and maximum loss -- is $92 per contract. Traders can use volumes here, and because our losses are capped, it does NOT require a margin account.

Our break-even points are $22.92 on the bottom and $27.08 on the top, requiring 10% drop or a 7.4% gain over the next eight-plus weeks. Max profit occurs at $25.00, of $208.

RIMM

Using similar strategies to our plays on HPQ results in the following:

1. Bear Call Spread

We will sell the October 28 for $350, and buy the October 32 for $194. Our net credit is $156. We maintain profit if RIMM stays below $29.56, with max loss above $32.00 at $244. Max profit occurs below $28.00 a share.

2. Short Straddle

Selling the October 28 straddle on RIM results in premiums received of $645. Our breakeven points are $21.55 (24.5% loss) on the downside, and $34.45 on a breakout (requiring a 20% gain). Looking out to March, a 29 straddle is bid at $10.15. Breakeven is $18.85 and $39.15, respectively.

3. Long Call Butterfly

For November (ahead of December earnings), we can construct a butterfly strategy for RIMM. We will buy the November 25 call for $580, sell 2 November 28 calls for $810, and buy the November 31 call for $280. Our net debit (and maximum loss) per contract is $50. Break-even is between $25.50 (10.7% loss) and $30.50 (6.7% gain), with maximum profit of $250 at the middle strike of $28.00.

Bear in mind these are just examples -- your strategies should match your own belief in the stocks, your risk tolerance, and your investment philosophy. But these different option trades show the flexibility and usefulness of using options to play predicted market trends. .

Disclosure: I have no position in the underlying stock, but I do have open neutral direction option trades on RIMM similar to those described above.