Dissecting The Family Dollar Store Earnings Options Trade

• Posted by Greg Harmon
• on July 1st, 2011

The Family Dollar Store (ticker: $FDO) released earnings Wednesday morning June 29 before the market opened. Tuesday morning prior to the market open I recommended an earnings trade using options which I took later that day. Here is how it went.

The Set Up:

Earnings can have a large impact on a stock price, or as from the last report a very minimal impact. Sometimes there are clues in the price action prior to the earnings release. This was the chart for $FDO on Tuesday afternoon. This stock had spent a lot of time between 51 and 54 over the last 3 months.

The Relative Strength Index (RSI) was vacillating around the mid line and it had a Moving Average Convergence Divergence (MACD) that was crossing back and forth around zero. No real future guidance from those. Notice that as it approached earnings it was also at a crossroads of the two Andrew’s Pitchforks. The green Lower Median Line was looking to carry it higher through July while the Red Upper Median Line looked to keep it from rising. As these two intersect it will have to choose a path and what better time to do that than after the earnings release. If it does make a move and jumps one of the Median Lines, I expected it to stall for a little bit as it decided if it would retest that line or move to the central Median Line. With that thought in mind the options market presented an earnings trade.

Trade Idea: Sell July 55/50 Strangles

From the closing board of the July options from Monday selling the July 55 call for 65 cents and selling the July 50 put for 90 cents, or a total of $1.55 for the Strangle, gives you protection for a move from 48.45 up to 56.55 by July 15. A 15% band, 7.5% up and down from the close at 52.33, around a stock that has realized volatility of 21.14%.

The Trade:

Shortly after publishing that idea the stock started to move higher towards the top of the range, so I opted to leg into the Strangle by selling the calls after the stock started to fall slightly at $1.05, planning to sell the puts before the Tuesday close. Toward the middle of the of the day it started to fall and I sold the puts at 85 cents, for a total sale of $1.85 on the Strangle, much better than planned for. Toward the end of the day the implied volatility started to fall shrinking the value of both short options, that was a good sign.

They reported earnings and the market traded the stock down off of the open on Wednesday morning, before it started to move back higher. More importantly for my trade the implied volatility continued to drop and it did not move beyond the previous channel or Median Lines. I was able to buy back the Strangles at 85c for a gain of a $1.00 on the trade, closing it out shortly after 10:00 am.

The Takeaway – Reward vs Risk:

Some may wonder why I took the trade off right away, leaving 85 cents on the table. In fact as I write this Friday near noon the Strangle could be purchased for only 55 cents. The reason is in risk management. There was a potential to earn $1.85 from the trade if both sides expired worthless on July 15th. But on Wednesday morning that was 13 trading days away. The reward to risk ratio had shifted. By continuing to hold the short Strangles I would have been risking a $1 to make 85 cents. A poor trade off. Constantly re-evaluating the reward to risk ratio and acting when it no longer is in your favor helps to protect gains and prevent losses. This was a trade off of an event, not a long term play so it was important to act with that strategy.

If you like what you see above sign up for deeper analysis and trading strategy by using the Get Premium button above. As always you can see details of individual charts and more on my StockTwits page.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

blog comments powered by Disqus