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Are Coinstar, Inc. (CSTR) Shorts Hedging With Call Options?

Breaking down a bull call spread on CSTR

by 2/7/2013 11:04 AM
Stocks quoted in this article:

Front-month options are in demand ahead of earnings from Coinstar, Inc. (NASDAQ:CSTR - 51.41), with traders paying relatively lofty premiums to gamble on a short-term move. However, one option trader is taking the road less traveled, selling calls to offset the cost of his bullish play.

Within the first 90 minutes of trading, CSTR has seen roughly 16,000 calls cross the tape -- about 20 times the norm, and more than 12 times the number of CSTR puts exchanged. More than two-thirds of the action transpired at the out-of-the-money February 57.50 and 62.50 calls, which saw symmetrical blocks of 4,500 contracts change hands.

The 57.50-strike calls traded at the ask price of $1.50, suggesting they were bought, while the higher-strike calls traded at the bid price of $0.40, implying they were likely sold. Since volume exceeds open interest at both strikes, we can assume the strategist constructed a bull call spread for a net debit of $1.10 per pair of options.

By purchasing the 57.50-strike calls to open, the buyer is expecting a significant post-earnings rally for CSTR. However, since front-month options are so expensive at the moment -- as evidenced by the stock's Schaeffer's Volatility Index (SVI) in the 100th percentile of its annual range -- the investor trimmed his initial cost, maximum risk, and breakeven by writing the higher-strike calls. Now, the trader is risking just $1.10 (net debit), as opposed to $1.50, and he'll make money on a move north of $58.60 (bought strike plus net debit), as opposed to $59.

Coinstar SVI

By doing so, however, the speculator also capped his maximum potential reward at $3.90 (difference between strikes minus net debit), no matter how far CSTR should rally north of $62.50. Had he simply bought the 57.50-strike calls, his profit would increase with each step above breakeven, with his maximum reward theoretically unlimited.

From a broader sentiment standpoint, though, there could be an ulterior motive for implementing the spread. Short interest represents more than 47% of CSTR's total available float, and would take nearly 12 sessions to unwind, at the equity's average pace of trading. Against this backdrop, it's possible that the strategist constructed the out-of-the-money spread to hedge his short position ahead of tonight's earnings release.

At last check, CSTR has tacked on 0.2% to wink at the $51.41 level. Historically, the kiosk concern has topped analysts' bottom-line earnings estimates in each of the past four quarters, according to Thomson Reuters.


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