Support Looms for Big Blue

by Tyler Craig | April 23, 2013 1:44 pm

On the heels of disappointing earnings, IBM (NYSE:IBM[1]) has been taken behind the woodshed and beaten mercilessly. Since closing at $209.67 last Wednesday, shares have fallen more than 10% in the largest three-day selloff since the financial crisis of 2008. What’s more, the amount of volume during Friday’s down gap was the highest one-day volume spike we’ve seen since its Q3 earnings release in 2009.

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Although the freefall has turned the daily trend decisively lower, the weekly trend remains quite constructive. As shown in the accompanying chart, multiple support levels loom in the $187-$182 zone that should lead to a slowing in IBM’s decline, if not an outright rebound.

While stock traders might be waiting for more definitive signs of a bottom before snatching up shares, option traders have a bit more leeway in structuring positions to take advantage of the situation.

Let’s break down two potential plays: one to exploit a rebound, and one to exploit a slowdown in Big Blue’s current descent.

The Rebound

If you’re willing to bet IBM snaps back from its current oversold conditions, you could sell a May bull put spread. By using out-of-the-money options, we can position the expiration breakeven point a couple bucks below the current stock price to provide a small buffer in case the stock drops a bit further before the sellers are finally exhausted.

Sell the May 185-180 bull put spread for 90 cents or better. The max reward is limited to the initial 90 cents and will be captured if IBM remains above $185 by May expiration. The potential risk is limited to the distance between strikes minus the net credit, or $4.10. The expiration breakeven sits at $184.10, which means IBM would have to drop more than $6 from current levels before entering your expiration loss zone.

The Slowdown

If you dislike the idea of betting on an outright rebound, but agree that IBM isn’t likely to drop too much further, here’s your play. Enter a 1×2 May put ratio spread by buying the May 190 put and selling two May 185 puts for a net debit of 25 cents.

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The ideal outcome is to have IBM sitting right at the short strike ($185) of the spread at expiration. This would result in capturing the max profit of $4.75. Admittedly, the odds of IBM pinning right at the $185 strike are quite slim. However, the expiration profit zone extends from $180.25 to $189.75, providing a large range for the stock to trade in while still yielding a profit on the position.

If IBM rallies and ends up closing above $189.75, your upside risk is limited to the initial debit of 25 cents. However, because the trade involves selling a naked put, your downside risk is theoretically unlimited. The accompanying risk graph provides a nice visual of the suggested position.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

  1. IBM:

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