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Options Lab: Starbucks Corporation (SBUX)

Breaking down a hypothetical trade on SBUX

by 7/17/2014 12:16:59 PM
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Starbucks Corporation (NASDAQ:SBUX) hasn't done much in 2014, down 0.6% year-to-date at $78.24. Recently, the shares have been encountering overhead resistance near the $79.50 level, as well. So what would a person do if she wanted to bet bearishly on the ubiquitous java giant? One way to do so that offers a great risk-reward ratio is by buying puts. These contracts afford their owners the right to sell a stock at a specific price by a specific date, regardless of where it's trading on the Street.

Daily Chart of Starbucks Corporation (SBUX) since December 2013

Let's consider a hypothetical trade. Jane Doe thinks SBUX is going to run into trouble next week, as the company is scheduled to report earnings after the close on Thursday, July 24. Specifically, she thinks Starbucks will miss analysts' bottom-line expectations for the fiscal third quarter, and as a result, the shares will sink. Therefore, Jane decides to a buy a single August 77.50 put -- which is currently out of the money -- anticipating the equity will close below $77.50 on Friday, Aug. 15, when back-month contracts expire. At the time of her purchase, the contract was being asked at $1.66, meaning that breakeven on the trade is $75.84 (strike minus the premium paid). (On a side note, option premiums -- that is, prices -- tend to rise ahead of events, due to increased implied volatility.)

In terms of potential risk and reward, Jane's maximum risk is $166 -- which is the premium paid times 100, since one option contract represents 100 shares of the underlying equity. In other words, if SBUX finishes at or above $77.50 on Aug. 15, and Jane is still holding onto her long put, she will lose $166. On the other hand, Jane's maximum potential reward would be achieved if the stock fell all the way to zero. In this case, she would make $7,584, or the breakeven price times 100.

Of course, the chances of SBUX being at zero when the closing bell sounds on Aug. 15 are next to nothing. In a more real-life (but still hypothetical) scenario, suppose the shares close at $75.79 at August options expiration. If this were to happen, Jane would book a $5 profit (less any transaction fees), based on the difference between the at-expiration breakeven price and the actual expiration price, times 100. Alternatively, suppose SBUX ends at $75.94 when August contracts cease trading. If this were to happen, the weekly put would be in the money. However, because the actual expiration price is $0.10 above the breakeven price, Jane would lose $10 (plus any fees).

Before closing, it's worth noting that long puts can be used as hedges, too. For example, a Starbucks Corporation (NASDAQ:SBUX) shareholder -- let's call him John Doe -- may be bullish on the stock long term, but is nervous in the short term due the company's upcoming earnings report. If John owns 100 SBUX shares, he could purchase one August-dated put to lock in a minimum selling price (in this case, $77.50), even if the stock crashes over the next month.

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