Option Strangle Hits Tight-Collar Zone

04/11/2012 7:00 am EST

Focus: OPTIONS

This classic strangle would be profitable if shares of CarMax (KMX) remain confined in a rather wide range, writes Karee Venema, but the recent move down to the lower limit has the trade teetering on the brink of loss.

Option activity was heavy on CarMax, Inc. (KMX) throughout the session before the company reported earnings late last week. With traders anticipating KMX’s results, calls and puts traded at six times and three times their respective average daily volumes, respectively. In total, 5,818 call contracts were traded, as compared to 2,728 put contracts.

This preference for calls was just another day at the office for KMX, with the stock boasting a Schaeffer’s put/call open interest ratio (SOIR) of 0.66. In fact, this ratio ranked in the fifth percentile of its annual range, suggesting that near-term traders have very rarely been more call-heavy towards the equity during the past year.

Amid last week’s options-fueled session, one speculator used both calls and puts to employ a short strangle in the front-month series. One block of 72 April 34 puts crossed at the bid price of $0.90, while a symmetrical block of 72 April 35 calls traded at the bid price of $1.15, establishing an initial net credit of $2.05.

See related: How to Trade Option Strangles

In the best-case scenario, KMX would be pinned somewhere between $34 and $35 by the time the bell sounds on April 20. This will allow both legs to expire worthless and place the maximum profit of $2.05 into the trader’s pocket.

However, the investor is still able to come out ahead as long as the stock remains in the $31.95 -$37.05 range (put strike - net credit; call strike + net credit). Of course, the trader may have already closed out the position by then.

Even though KMX beat earnings estimates, it has been punished in recent sessions and dropped into the $31.85 region in yesterday’s trading.

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Overall, it’s a great example of how option spreads can help you make money in a range. If this trader had bought KMX outright prior to earnings, he/she would definitely have taken a loss. The option trade gave the ability to make money in a price range, but even this option spread trade is right on the edge of losing money as of right now.

By Karee Venema of Schaeffer’s Investment Research

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