How One Trader Used Options Prior to eBay Earnings

01/21/2011 3:03 am EST

Focus: OPTIONS

Joseph Hargett

Financial Analyst, Schaeffer's Investment Research, Inc.

Online auctioneer eBay Inc. (EBAY) attracted quite a bit of attention from put traders, as options speculators positioned themselves ahead of the company’s quarterly earnings report. EBAY was expected to post a profit of 42 cents per share, up from earnings of 37 cents per share in the same quarter last year. Historically, the company has bested the consensus view in three of the prior four reporting periods, with an average upside surprise of roughly 8%. They did so this time as well and the stock has headed higher

Returning to the options pits yesterday, more than 10,800 puts changed hands on EBAY by mid-day, nearly quadrupling the stock's average daily put volume. The most popular put was the January 2011 30 strike, where some 7,000 contracts crossed the tape.

Taking a closer look at 30-strike activity, however, reveals that there was at least one trader with neither bullish nor bearish designs on EBAY. Specifically, the online auction house appears to have been targeted by a calendar spread trader.

For the uninitiated, calendar spreads are generally neutral in terms of movement in the underlying stock—though you can skew the spread bullishly or bearishly by altering the strike prices. Ultimately, this strategy is designed to take advantage of declining implied volatility, with the trader typically betting on little to no movement from the underlying stock. By entering the calendar spreads ahead of eBay's quarterly report, the trader was essentially betting that the stock would go nowhere, and that implied volatility would implode as a result.

Getting down to the trade itself, a block of 151 January 2011 30 calls traded at about 11:13 am ET on the Chicago Board Options Exchange (CBOE) for the bid price of $0.54. At the same time, and on the same exchange, 151 February 30 calls changed hands for the ask price of $0.90. Given this data, it would appear that we are looking at a potential calendar spread on eBay. This strategy is also known as a time spread, or a horizontal spread.


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The Anatomy of an eBay Calendar Spread

Now, this set-up is not typically for the beginning options trader because there are several moving pieces to this trade, but the trader above is looking for accelerated erosion in the implied volatility of the front-month option, which he hopes to buy back at expiration for practically nothing, while collecting a larger premium by selling to close the back-month option.

Drilling down on today's EBAY calendar spread, the trader sold 151 January 30 calls for $8,154 [($0.54 x 100) x 151]. At the same time, the trader purchased 151 February 30 calls for $13,590 [($0.90 x 100) x 151]. The total outlay for this position would be $5,436 ($13,590 - $8,154).


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The maximum loss on this trade is limited to the initial net debit of $0.36, or $36 per pair of contracts. Meanwhile, the maximum profit is limited to the premium received for the back-month option when it is sold to close out the position, minus the cost to buy back the front-month call, minus the net debit paid to establish the position. The maximum profit is achieved if EBAY closes at $30 per share on January expiration.

Since there are two expiration dates for this trade, and we cannot know for certain what the exact value of the February 30 call will be when the January 30 call expires, we can only estimate the approximate return on the EBAY calendar spread. In the best-case scenario, EBAY would close at the 30 strike when January options expire, allowing the January 30 call to expire worthless. At that point, the February 30 call would be worth only its time value and implied volatility—no intrinsic value.

In this example, the February 30 call will be worth an estimated $1.31 at January expiration, according to IVolatility.com's pricing calculator, allowing the trader to sell to close the position for $131 per contract. After subtracting out the cost of the position ($0.36), the trader would snag a profit of $0.95, or $95 per contract. Below is a chart for a rough visual representation:


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Implied Volatility

The most ideal calendar spread trade occurs when near-month implied volatilities are high relative to options with a longer life. Optimally, the spread trader needs implied volatility to remain steady on the shorter-term sold option (or to increase on the purchased option). The best-case scenario for a calendar spread is that the sold option expires out of the money, while the purchased option retains time premium.

At the time of the trade, implied volatility (IV) for the EBAY January 30 call arrived at 78.83%, while the IV for the February 30 call rested at 35.30%. For comparison, as of the close of trading on Tuesday, EBAY's one-month historical volatility rested at 24.42%, while the stock's two-month historical volatility was 25.94%.

Depending on when or if this trader closed out this position, he or she may have made or lost money. Volatility increased with the announcement, so they may have lost if they held it into the announcement. However, the loss is limited, so it is a relatively “safe” way to play a news event. “Safe” is a relative term, of course. Be sure to practice this type of trade with a paper account first if you are a newer option trader.

By Jospeh Hargett, contributor, Schaeffer’s Trading Floor Blog

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