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Options Update: Cisco Systems Short Straddled Ahead of Earnings

Technology bellwether sees unusual call and put activity ahead of earnings

by Joseph Hargett (jhargett@sir-inc.com) 11/3/2009 1:30 PM


Cisco Systems Inc. (CSCO: View sentiment for CSCOsentiment, chart, options) is expected to report a third-quarter profit of 31 cents per share after the close of trading tomorrow night. Earnings reports are not only capable of sparking large moves in a security, but they can also be responsible for lifting implied volatility heading into the event. Judging by CSCO's options activity in today's trading, it appears that at least one trader is betting on the latter.

Overall, puts appear to be the investment vehicle of choice for CSCO options traders this afternoon. Specifically, put volume has more than doubled the stock's daily average, with more than 12,000 of these bearishly oriented contracts changing hands. The most popular strike is the January 2010 25 put, where more than 10,000 contracts have changed hands. However, after rummaging through the activity, I uncovered a much more interesting trade at the November 23 put.

The trade that caught my attention consisted of a block of 700 CSCO November 23 puts that traded for the bid price of $0.82, or $82 per contract, on the Philadelphia Stock Exchange (PHLX) at about 10:41 a.m. Eastern time. This trade was marked "straddle." Digging through CSCO's call option activity revealed that the other leg of this straddle traded on the November 23 strike. Trading at the same time on the PHLX, a block of 700 November 23 calls crossed the tape for the bid price of $0.68, or $68 per contract. This trade was also marked "straddle." Given this data, it would appear that we are looking at a short straddle on Cisco Systems ahead of earnings.



CSCO Nov. 23 put and call volume

The Anatomy of a Cisco Systems Short Straddle

There are two ways that a short straddle trader can profit from this options strategy. The most lucrative is when the underlying stock closes at the sold strike on expiration. Such a development means that both the sold put and call will expire worthless, allowing the trader to retain the entire premium received upon entering the position. The second path to profit involves a decline in implied volatility, thus making the options less expensive to repurchase, and allowing the trader to pocket the difference.

Since the trader is selling premium on both a put and a call, the position has plenty of risks. Theoretically, if the stock rallies, losses are unlimited, as there is no limit to how high the shares can move before the trader is forced to purchase them to fill the exercised call option. Meanwhile, losses on a downside move are capped at the strike price minus the premium received on a decline in the equity.

Turning to today's CSCO short straddle, the trade breaks down like this: The trader receives a credit of $57,400 for selling 700 November 23 puts -- ($0.82 * 100) * 700 = $57,400 -- and a credit of $47,600 for selling 700 November 23 calls -- ($0.68 * 100) * 700 = $47,600. The total credit received for the position arrives at $1.50 , or $105,000 -- [($0.82 + $0.68) * 100] * 700 = $105,000.



CSCO short straddle breakdown

The position reaches its maximum profit if CSCO closes at $23 per share on expiration. In this scenario, both the sold November 23 call and put would expire worthless, allowing the trader to keep all of the premium collected.

There are two breakeven points for this position. They are calculated by adding and subtracting the net credit received to/from the sold strike. For the example, the breakevens are $24.50 -- 23 + $1.50 = $24.50 -- and $21.50 -- 23 - $1.50 = $21.50. Finally, the maximum loss on a downside move is limited to the strike price minus the net credit received, or $1,505,000 -- [($23 - $1.50) * 100] * 700 = $1,505,000. Meanwhile, the maximum loss on an upside move is theoretically unlimited. Below is a chart for a rough visual representation:



CSCO short straddle profit/loss chart

Implied Volatility

As noted above, implied volatility is another key factor to consider when entering a short straddle position, as a decline in implieds can be an alternate route to profit on the position. Since the trader is selling the options, he is looking for inflated premiums at the start of the trade in order to maximize the net credit on the trade. Currently, implieds for the November 23 call arrive at 37%, while the implied volatility for the November 23 put rests at 38%.

For perspective, CSCO's one-month historical volatility is currently perched at 22.98%, meaning the aforementioned options are relatively expensive from a historical perspective. By playing this short straddle ahead of earnings, the trader appears to be taking advantage of bid-up premiums heading into a known event. Usually, implied volatility declines following these events. As such, the trader may be able to buy back one or both of his options at a lower price, thus pocketing the difference in the process.




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