How to Trade Chipotle Volatility Ahead of Earnings

by Tyler Craig | April 17, 2012 8:10 am

How to Trade Chipotle Volatility Ahead of Earnings

Restaurant Fast Food Chipotle 300x199 How to Trade Chipotle Volatility Ahead of Earnings[1]Everyone’s favorite burrito maker, Chipotle Mexican Grill Inc. (NYSE: CMG[2]) is set to post earnings after the bell on April 19 (Thursday).  Year-to-date, CMG is up 28%, outpacing the S&P 500 Index (SPX[3]) by a hefty margin.

Options traders looking to play this name might consider something other than making a directional bet into the announcement (which is always a roll of the dice). Instead, let’s take a volatility look at expectations heading into Thursday’s report.

Since CMG reports earnings the day before April options expire, we can simply analyze the price of April straddles or strangles to determine the expected move. CMG closed at $432 on Monday and the April 430-435 strangle (buying the 435 call and the 430 put) was trading at $22.

To break even, strangle buyers[4] would need CMG to rise to $457 or fall to $408 by the end of day on Friday – a move of roughly 5.5%. That is the call strike plus the total strangle premium paid and the put strike less this premium. Traders anticipating a move larger than this should lean toward being volatility buyers into the announcement.

On the flip side, those traders betting on a move within this range should look to be volatility sellers. If CMG is trading between these strike prices when the option expires, a short strangle would be successful.

When playing the earnings game, it often helps to investigate how well straddles have been priced during past quarters. Of the past seven releases in CMG, straddle buyers have only come out ahead twice. The other five times rewarded those that stepped up and sold volatility into the number. So the odds definitely favor selling volatility, but that actually shouldn’t be that surprising for those familiar with how options are priced around earnings. Volatility sellers almost always have the edge heading into the release.

The pesky caveat is that occasionally volatility sellers can be spectacularly wrong and the losing trades can quickly dwarf the winners. Short strangles have limited profit potential but carry unlimited risk. As a result, blindly shorting volatility into every announcement unfortunately isn’t as much of a slam-dunk as many hope it is.CMG 300x210 How to Trade Chipotle Volatility Ahead of Earnings
Click to Enlarge

Traders looking to sell volatility on CMG might instead consider May-dated iron condors. This four-legged strategy consists of simultaneously selling a bull put spread and a bear call spread. Currently the May 380-385-480-485 condor can be sold for a credit of roughly $1.27. That’s buying the 380-strike put and selling the 385-strike put, selling the 480-strike call, and selling the 485-strike call.

The maximum potential loss for this iron condor is $3.73, or the difference in call/put strikes less the credit. Maximum loss will occur if CMG is trading above the 485 strike or below the 380 strike when the May options expire. That’s a move of 12% in either direction.

In the event CMG gaps less than expected, the post-earnings volatility crush should diminish the value of the condor and allow you to buy it back at a lower price, keeping the difference as profit.

At the time of this writing, Tyler Craig had no positions on CMG. 

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2011/05/Restaurant-Fast-Food-Chipotle.jpg
  2. CMG: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMG
  3. SPX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPX
  4. strangle buyers: http://investorplace.com/2011/03/options-strategies-long-strangle/

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