In the wake of Wal-Mart’s (NYSE:WMT) ill-received earnings report, options traders are scurrying to set up a short-term play. For the fourth quarter, Wal-Mart earned $1.50 per share (before items); this compares to $1.70 in the year-earlier quarter. Comparable-store sales figures rose, but just by 1.5%, which was shy of most analysts’ projections.
WMT shares responded by gapping 3.5% lower out of the gate and continuing to lose momentum throughout the session, ending down 3.9% at $60.07. This is a sizable single-day move for this usually stable blue chip — the stock’s 30-day historical volatility reading is just 8.6%.
By the end of Tuesday’s trading session, about 89,000 total options had already traded on WMT (59,000 calls and 30,000 puts). This compared to Friday’s overall option volume of 53,000 and average option volume around 30,000 contracts.
Long Call Buyers in Control?
More than 4,000 contracts traded at the Feb. 24 60-strike call option. This near-the-money weekly option, which expires at the close of Friday’s trading, had open interest of just 54 contracts heading into Tuesday’s session. The volume, therefore, consists of new activity, and it looks as though these calls were purchased for an average premium of around 43 cents apiece.
For these calls to be profitable, WMT needs to rise above $60.43 by Friday’s close. That’s a move of just 0.6% or so, but the move needs to happen in a few days’ time. And the closer these weekly options get to expiration, the more rapidly their respective time value will deteriorate. Gains are potentially unlimited if WMT charges higher, but traders risk losing 100% of the 43-cent premium paid if WMT is trading below $60 when the options expire.
Or Short-Term Volatility Traders?
Of course, option traders might have another strategy in mind — the long straddle. In addition to the aforementioned call activity, WMT also saw just over 5,000 contracts change hands at the Feb. 24 60-strike put option. Open interest at this put was unremarkable ahead of Tuesday’s trading, so it appears that this volume also consisted of new short-term bets.
A straddle does not aim to predict a stock’s direction; it projects the magnitude. For long straddle to succeed, the underlying shares need to move in either direction (as long as they move). In the example of Wal-Mart, the calls traded for about 43 cents apiece while the puts traded in the neighborhood of 30 cents.
To break even, WMT would need to move 73 cents above or below the 60 strike, to $60.73 or $59.27, respectively. Above or below these levels, the straddle becomes profitable. Gains are unlimited to the upside and capped only by zero if the shares decline. Losses for a long straddle, meanwhile, are limited to the total premium paid for the combined call and put (73 cents, give or take).
Given the similarity in volume at these short-term 60-strike options, it could be that Tuesday’s active option traders are adopting the long-straddle strategy.
Either way, these investors are expecting to see WMT continue to move in the next few sessions through the end of the week.
As of this writing, Beth Gaston Moon did not hold a position in any of the aforementioned securities.