This retailer is expected to move big this week on earnings. How to profit on it using options

Published Mon, Mar 4 202410:56 AM EST

We'll review the concept of implied volatility and put that knowledge to work on a trade example involving Foot Locker, which is expected to have a big move after earnings this week. Implied volatility sounds wonky. It refers to the estimated future volatility of the underlying asset through a future (expiration) date. Leaving the fancy options mumbo jumbo to the side, it's just another way options traders think about the price of an option . This is because of all the key inputs that go into the models traders use to determine the value of an option such as the current stock price, the strike, whether the option is a call or a put, the expiration date, dividends and rates are all known. It is only the future volatility of the underlying stock — which the option model also needs to calculate an option's value — that is really just an estimate. Since inputting a volatility estimate can output a "value" (or price) for an option, we can also simply put in the current price of an option as observed in the market and solve for the volatility estimate; also known as the implied volatility. It is because inputting volatility solves for price, or inputting price solves for volatility, that options traders tend to think of the two interchangeably. For traders and investors who are not options market-makers though, it's only important to understand the idea at a high-level, and here's why. The estimate of future volatility (and therefore the price of options that expire after the event) will tend to be higher before the event than after the news comes out. When option traders refer to "vol suck" or "vol crush" they are referring to the decline in the future estimated volatility after the news comes out. A move in the expected direction may help, but the decline in the estimate of future movement might not. It is this dynamic that often causes heartburn for some traders and investors when they purchase options to try and make a directional bet going into an event like earnings. It's occasionally possible to get the chosen direction right, but if the magnitude of the move is not sufficient, the trader will not see profits. Big move expected for Foot Locker In the table below, we highlight some of the stocks reporting this week where options prices estimate fairly high moves around earnings. Foot Locker (FL) reports Wednesday before the open and the options market is implying a substantial 16% move, higher or lower, following their earnings release. Why is this? And is there a way to trade it? First it's important to recognize that Foot Locker has been a volatile stock. As the 10 year chart below shows, it rallied more than 250% of the pandemic plunge low to nearly $65/share in May 2021. It has fallen ~45% since and is down more than 55% from the all time highs back in 2016. Foot locker did very well after they reported their last quarterly earnings in late November as the stock rallied over 15% that week. Three weeks later, Foot Locker's largest supplier Nike's results disappointed the street, forecasting a decline in 3Q sales. Its shares fell more than 11% and Foot Locker fell about 5% or so in sympathy. Curiously, while Nike has not recovered since then, Foot Locker has, and even more curiously this is despite the fact that while the earnings of these two companies are related — as this 10-year chart of EPS illustrates — operationally Foot Locker has not managed to keep pace with the sportswear juggernaut Nike in recent years. So which price action is to be believed? Nike's, which has been weak, down more than 6% year to date, or Foot Locker's which is up 11%? And how does one play it given that Foot Locker options are incredibly expensive? The trade One way is to use a long "calendar spread". Purchasing a longer-dated options while selling a nearer-dated option to help offset the cost, such as the March 8th weekly $31 strike, June $30 strike put spread. Purchasing the longer dated June $30s and selling the nearer dated March 8th weekly $31s for a net debit of $1.23. (Note there is no $31 strike put listed in June).That trade would look something like this : The trade: Buy Jun. 21 $30 put Sell March 8 $31 put (Note Foot Locker closed Friday at $34.60) As the payoff diagram illustrates this trade leans bearish, suggesting that perhaps Nike's less optimistic forecast proves accurate. Of course one who is more sanguine could take a more optimistic approach and use an upside call calendar instead. The March 8th weekly $37/June $37.5 call calendar would create a payoff profile like this one : Of course the longer-dated June options will see some of the "vol crush" we described earlier, but an important note about that: The June options capture both this week's earnings, but also the earnings the company will be reporting in May. So while we will see June options premiums decline as soon as earnings are released this week, they will still need to bake in the next one. DISCLOSURES: (None) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL'S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.