The right spread at the right time

Traders and investors often think about the rewards and risks associated with “big” price moves, but as recent history illustrates, markets often spend a great deal of time not doing much of anything.

Edwards Lifesciences (EW) is a good example. Although the stock is up more than 18% this year—and hit an eight-month high as recently as Monday—it’s lost momentum since the company released earnings in late April:

That loss of price momentum has also been accompanied by a decline in EW’s options volatility. The stock appeared on the LiveAction scan for 52-week low implied volatility (IV) on Tuesday morning, even as the stock was slipping to downside along with the broad market.

Let’s say a trader expected the stock to move sideways to lower over the next several weeks. Given that IV was relatively low—and low IV can mean options are moderately priced—buying put options may have seemed like an appropriate strategy.

One catch: While Low IV can be advantageous for options buyers, it doesn’t address the other challenge facing a long options position—time decay. One of the most common ways options traders try to offset this drawback is to combine long and short options in a spread position: The long options can capitalize on a directional (up or down) move in the stock, while the short options benefit from time decay—thus offsetting some of the disadvantage of a long-only position.

For example, a trader expecting a stock to make a limited down move in the near future may—instead of simply buying puts—use a vertical (bear) put spread, which in its most basic form combines a long at-the-money put with a short out-of-the-money (lower-strike) put. The premium collected from selling the put means the trader’s up-front cost is lower than it would be for a long-put position, but it also means the trade’s maximum profit is, along with its risk, capped:

On Tuesday morning, for example, when EW was trading around $88.70, a trader could have bought the June $90-$85 put spread (long the $90 put and short the $85 put) for roughly 60% less than the cost of buying the $90 put outright.

True, the spread wouldn’t capture as much profit as the long put in the event of an exceptionally large down move, but markets don’t always produce those types of moves. The vertical spread can be viable choice for traders expecting a limited move in a relatively short time window—that is, in situations when prices may not be doing much, but may do enough to make a limited-risk, limited-reward trade worthwhile.

Market Mover Update: Tuesday’s retail sales data was mixed but resilient, but the week’s first high-profile retail-sector earnings announcement, from Home Depot (HD), missed estimates expectations. The stock fell as much as 4% intraday, but later cut that loss in half.

After jumping 31% on Monday in the wake of the Food and Drug Administration’s favorable ruling on its muscular dystrophy gene therapy,¹ Sarepta Therapeutics (SRPT) pulled back more than 3% on Tuesday (see “Dueling volatility catalysts”). It also landed on the LiveAction scan for biggest one-week IV declines.

Today’s numbers include (all times ET): Housing Starts and Building Permits (8:30 a.m.).

Today’s earnings include: Target (TGT), TJX (TJX), Copart (CPRT), Cisco (CSCO), Sociedad Quimica y Minera (SQM), Take-Two Interactive Software (TTWO).

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