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Options Lab: Cree, Inc. (CREE)

Breaking down a hypothetical trade on CREE

by 8/12/2014 9:41:10 AM
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Cree, Inc. (NASDAQ:CREE) has had a depressing 2014, with the shares off more than 20% year-to-date, based on Monday's closing price of $49.69. What's more, the stock has recently struggled with resistance in the round-number $50 area, which corresponds with the equity's descending 100-day moving average (located at $50.19) and high levels of front-month call open interest at the August 50 strike. Based on this bleak picture, we want to examine one way to use options to bet on extended downside for CREE.

Daily Chart of Cree (CREE) since January 2014 With 100-Day Moving Average

Today, we'll consider a hypothetical options trader -- let's call him Mike -- who wants to bet on a post-earnings sell-off for CREE, which is scheduled to report this evening. This makes sense historically; while the company has matched or exceeded the Street's per-share profit projections in each of the past seven quarters, the stock has averaged a 4.4% loss in the ensuing three sessions. Therefore, Mike decides to gamble on an end-of-week tumble in the shares by buying to open 10 August 49 puts at an ask price of $1.83 each. However, because CREE has recently found a foothold in the $47 area, he also sells to open 10 August 47 puts at a bid price of $1.00 apiece. In so doing, Mike offsets a portion of the premium he's paying, yielding an initial net debit of $0.83 per pair of contracts, or $830 total (premium paid * 10 pairs of contracts * 100 shares per contract).

By initiating the long put spread, Mike will profit at expiration if CREE is below the breakeven mark of $48.17 (bought strike less net debit). Had he bought the put outright, his breakeven mark would be $47.17 (strike less premium paid). Additional gains will accrue on a move down to the sold strike, for a maximum potential profit of $1.17 (difference between strikes, less net debit), or $1,170 total (profit * number of contracts * 100 shares per contract). By contrast, Mike's maximum potential loss is never greater than his initial net debit of $830, which he will forfeit if CREE settles at or above $49 at the close this Friday, when the front-month options expire. Although forfeiting a portion of his potential profit by selling the put, he has also reduced his risk, which would have been $1,830 (premium paid * number of contracts * 100 shares per contract) had he simply bought the put outright.

That being said, let's run the foregoing scenario through a couple of hypothetical outcomes. Suppose CREE is resting at $48.50 at week's end -- that is, below the bought strike ($49), but above breakeven ($48.17). If this happens, Mike will lose $0.33 per pair of contracts (actual price less breakeven price), or $330 total, plus any brokerage fees. Alternatively, suppose Cree, Inc. (NASDAQ:CREE) finishes the week at $48; in this case, he'll make $0.13 per pair of contracts, or $130 total, less any brokerage fees.


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