Now that the holiday season is over, retailers are looking to unload unsold merchandise at probably considerable savings which is good news for consumers. The same can be said of option traders — they are always looking to buy low and sell high or vice versa. Here is a trade idea on a retailer, Best Buy (BBY), that might just be too good of a deal to pass on.
Best Buy (BBY — $40.68): Diagonal Spread
The trade: Buy the BBY Feb 40 calls and simultaneously sell the Jan 42 calls for a net debit of $1.85 or better.
The strategy: A diagonal spread — essentially a time spread — involves buying one option and selling another option with a different strike and different expiration month. The goal in this instance is for the stock to trend slowly up and eventually help pay for the long-term call with the short-term call’s premium received. It is somewhat similar to a covered call, but instead of owning the stock, a long-term call is purchased instead. Also, creating a spread trade like this lowers the overall cost of the trade compared to a long call position.
A perfect-case scenario is for BBY stock to be slowly moving higher and be trading right at the short-term call’s strike at expiration. The short call would expire worthless, and the long call increases in value minus some time decay. The most that can be lost is what was paid for the spread, and that would happen if BBY stock is trading below $40 at the February calls’ expiration.
The rationale: Best Buy is really a company that turned things around. Best Buy was on the verge of bankruptcy and BBY stock traded around $12 at the end of 2012, but the company has been able to take steps to improve the business and the stock price. Best Buy just recently announced a two-day promotion where they were giving away the iPhone 5C or the Galaxy S4 with a two-year contract agreement. Innovative moves like this could be the reason the company is doing better.
Click to Enlarge The real reason this trade idea looks good is because of the chart and the implied volatility of the options. BBY stock has been trading in a range between about $40 and $42 since the beginning of December. BBY currently looks poised to move up and test the $42 resistance area — the 50-day simple moving average is hanging out just below that.
What makes this diagonal spread desirable from an options point of view is the implied volatility of the options. The IV of the short January options are greater than the IV of the long February options, meaning the sold options are priced a bit more expensive than the long options.
Selling more expensive options than those you buy is a smart move worthy of a Best Buy promotion!
As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities. Get a free trial of John’s live options trading room here.