An Earnings Play on Intuitive Surgical

 | Jul 22, 2014 | 1:05 PM EDT  | Comments
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Even in the full swing of earnings season, Bill Ackman has commanded center stage with his presentation on HerbaLife (HLF) today in an attempt to demonstrate how this company is a fraud. But wait, didn't he do one already? Why, yes, and he's done it several times, as a matter of fact. He'll keep doing it, too, as long as he has an audience.

I find it entertaining, but I will not trade around it. There are just too many unknowns for me. Maybe Ackman is right and the stock will get cut in half. Maybe he's not and it will regain recent highs. The issue is, I have no idea if he is correct, nor do I know what facts he has or does not have. There is absolutely nothing to trade off of for me. The only thing I would consider is watching the implied volatility around the stock and making a trade there. But, really, I don't want to become financially involved in that circus act.

Instead, I'll stick to earnings trades for the week. It's a high-wire act on its own, but one that I've learned to cross quite often without falling.

Netflix (NFLX) provided a small winner on Monday. It was a little disappointing, as I did need that $25 move and the stock is only down $18 right now. It was a very complex trade, and I was only able to net $0.45 from the first two-thirds. Percentage-wise, this looks huge from my total entry cost of $0.15, but the reality of holding naked straddles on Netflix meant there were plenty of margin requirements, so the return really wasn't spectacular at all.

I've left a small runner on the put side for the Netflix trade, even as I am doing nothing to the call side at the moment. Later on today, I may buy back my net short calls if I can get them for a penny or maybe two.

This aside, when it comes to earnings I have a love-hate relationship with Intuitive Surgical (ISRG), which is due to report tonight after the open. I love to trade it, but I hate the spreads on the options. I'm adding a second slide today in the hopes of providing a slightly better outline on my thinking into earnings trades -- scary, I know.

My initial approach for Intuitive lies in looking at how the stock has done over the past four earnings releases -- and, having done this, I can report that the current chart is nothing new. The stock has not only opened lower, but significantly so, for the last four reports in a row. I will stay with trends until they end. This worked well for Chipotle Mexican Grill (CMG) and NetScout Systems (NTCT) already this season.

While Intuitive Surgical has only closed above the straddle pricing once in the past four years, on an intraday basis it traded well above the implied move twice and was very close to it the other two times. This leads me to conclude that a straddle play is quite possible this time around. However, based on the closing values, profit expectations should be nominal. These reports simply have not been home runs, nor have they been strikeouts. It looks like a lot of risk for ho-hum returns on either buying or selling straddles. When that is my conclusion, it's best to just shelve the idea.

A few things certainly come to mind, though. First, near the top of the list, is the idea of selling bearish call spreads. Granted, this wasn't a great approach for Crocs (CROX), a trade I announced on Real Money Pro Monday. However, the grid profile in this stock was different in this stock from that of Intuitive, as Crocs put in three rather flat opens and two reversals after its last few earnings reports. As a result, it was absolutely in play to sell a call spread in that name.

Looking for a short play in Intuitive is also on the table. Intuitive options are pricing in a move that's very similar to what we've seen over the past year, so the puts aren't any more expensive now than they were previously, even after four quarters of the same pattern. That said, puts will still require a good-size move.

Given the past results, an at-the-money put is going to require a move ranging between some 4% lower and breakeven. Rather than doing a July $395 put, though, I would consider targeting a spread with the short leg around 7% out of the money. This would lower the breakeven to a 3% move lower. I would still be risking the same amount of capital, though. A put spread will have a smaller delta, so it won't move as much per dollar in the underlying stock as a simple put would.

The stock has faded from the open the past two times following its rallies in the prior two instances. Again, this is too much of a coin flip, so I'm not looking for a fade or a trend play. Here's what I am really drawn toward: The average open and average close are very consistent post-earnings. The maximum intraday low doesn't tend to be much off the open, nor is the close usually too far off the open -- and that makes this one perfect for a combination or butterfly trade. "Perfect" doesn't mean a guaranteed profit, but it makes for a fantastic risk-reward scenario over time.

So, having seen the average Intuitive post-earnings close (down 7.6%), the best close (down 5.7%) and the worst close (down 11.5%), I can formulate a butterfly or unbalanced butterfly.

I want my first long leg -- the one closest to the current price -- to be better than the best close. Since that one saw the stock slide 5.7%, I am going to want a decline that ranges between 2% and 4%. I then want to target the average close as the midpoint of my butterfly for the short legs, assuming the closes are relatively near the current level -- which they are. Here, we see three of those four post-earnings closes ranging between 5.7% and 6.8% declines. Therefore, I want my short leg to be in the range of down 7% to down 10%.

I like to leave a little room to maximize potential value, to take into consideration the worst leg and also to try minimizing remaining time value. If Intuitive drops 6.5% tomorrow, a short put that's currently 6% out-of-the-money will be right at the money -- and it will still hold a decent amount of time value, as well, since there will still be three more trading days in the week.

Since this is a butterfly, once I have my first two legs, my last leg strike will take care of itself. They will be equally spaced, so if my first long leg is down 4% and my short leg is down 8%, my last long leg will be off 12%. I really won't want to have my last long leg to be down more than 14%, since the stock has only been below that level once on an intraday basis over the last four reports.

Note that I'm basing this on last night's close -- so, given that Intuitive was recently trading higher, I suggest adjusting the numbers before you make a trade. On the surface, my preferred butterfly is the one that is long a put 4% out-of-the-money, short 2x puts 8% out of the money and long 1 put 12% out of the money. This would be about $15 wide with a cost around $3.25. If the trade hits perfectly, it will generate about a $4.75 reward for every $1 worth of risk.

As of now, I am going to bid on one slightly more tightly: a July $385-370-355 put butterfly for $2.50 or less. The other I like is a $382.5-$365-$347.50, for $2.90 or less.

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