Spreading your trade choices

05/17/19
  • ALRM implied volatility down more than 44% from last week
  • Stock dropped sharply after May 9 earnings beat
  • Shares sharply higher yesterday

Yesterday, home automation and security tech company Alarm.com (ALRM) had a big up day, but its volatility drop may have been more notable. Then again, it’s probably the combination of the two that may pique trader interest.

Options traders know implied volatility (IV), which is the market estimate of future volatility reflected in an option’s price, often jumps in the run-up to an earnings release and retreats just as dramatically after one.

Options tend to increase in value as IV increases, as traders charge a greater premium for the uncertainty surrounding any earnings announcement. After the numbers come out, the uncertainty evaporates and, usually, so does a lot of the IV.

LiveAction scan: Large one-week IV declines, 5/16/19. Unusual options activity. ALRM implied volatility down -44.56%.

Source: Power E*TRADE


So even though ALRM rallied more than 3% yesterday, its appearance on a LiveAction scan for big one-week IV declines wasn’t unusual, since the company released earnings on May 9. Yesterday morning, ALRM implied volatility was down -44.56% from the week prior.

Although ALRM beat its headline earnings and revenue numbers, the report also highlighted a decelerating earnings growth rate,1 something that may have contributed to the stock’s roughly 17% drop in the four days after the release. ALRM shares traded as low as $57.60 on Wednesday before turning sharply higher yesterday:

Alarm.com (ALRM), 10/25/18–5/16/19. Alarm.com (ALRM) price chart. Rally after post-earnings sell-off.

Source: Power E*TRADE


Before last week’s stumble, the stock was up more than 34% on the year, and was just off it’s all-time high of $71.50 from three days earlier.

When a stock makes a big move like ALRM did yesterday—i.e., one that reverses the short-term move that immediately preceded it—it can sometimes be an indication that the move has run its course, at least for a while. In this case, bulls looking for an extension of yesterday’s rebound could buy the stock, while others may use call options—not just because they offer greater leverage than a stock trade, but because this week’s IV drop is likely to make them more affordable than they’ve been in several days.

In addition to buying call options, which should gain value if the stock rallies, some traders may choose to combine options (in a “spread”) to create a trade with specific risk-reward characteristics.

ALRM June $60-$67.50 call spread, 5/16/19. Bull call option spread profile 68% potential return on rally to $67.50.

Source: Power E*TRADE


The chart above, for example, shows the profit-loss profile for a “bull call spread” consisting of a long June $60 call and a short June $67.50 put (total cost: $280 per spread). The long $60 call should increase in value if the stock rallies, while the short $67.50 call offsets some of the cost of that option (in this case about 10% of it). The trade-off is that the position’s profit is capped no matter how high the stock rallies.

But for traders simply looking for a short-term rebound, the leverage offered by options can sometimes make it an attractive alternative to a stock position. In this case, for example, buying ALRM stock at $60 and selling it at $67.50 would represent a 12.5% return, while the spread would be worth $470 at expiration if the stock is trading at $67.50 or higher—a 68% return on the cost of the spread.

Every trader needs to choose strategies that reflect both their market expectations and their risk tolerance.

Market Mover Update: Traders will have to wait to see if the three tech stocks mentioned in “Tech talk: Plan your trade, trade your plan” (CSCO, MSFT, SHOP) retreat to their estimated retracement levels, as they all gained 2%-7% yesterday. Centene (CNC) rallied more than 2% (see “Let’s make a deal”).

Today’s numbers (all times ET): Consumer Sentiment (10 a.m.), E-Commerce Retail Sales (10 a.m.), Leading Indicators (10 a.m.), Baker-Hughes Oil Rig Count 1 p.m.).

Today’s earnings include: Deere (DE).

 

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1 Investor’s Business Daily. Alarm.com Stock Tumbles On Slowing Earnings Growth. 5/10/19.

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