Arcángel de Jesús Montoya
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Arcángel de Jesús Montoya in Money Trafficking,

Make 14% With Square's May's Options

Square (SQ) is reporting quarterly results on May 5, 2016. Analysts expect quarterly EPS of (0.09) on sales of around $340M:

(Source: TD Waterhouse)

The company is not expecting to be profitable during this year, yet, according to Motley Fool, it plans to turn positive EBITDA of $6M to $12M. This is not significant at all, given that in the last year the company showed EBITDA of ($47M) on sales of over $1.25B! The stock has not been showing spectacular return since its IPO in November 2015:

(Source: YCharts) 

As you can see, the volatility has been brutal over the last several months. The stock is currently up 8.5% relative to S&P 500 after underperforming the index by 35% in February 2016. As you can guess, the stock's options are expensive relative to other companies' derivatives:

(Source: Google Finance)

The straddle with the closest expiration on May 20 is currently trading at ~14% of the stock's market value. This translates into a staggering annual volatility of around 60%! Our credo is to buy low and sell high, while also hedging our downside. I checked a few options strategies and found that the best options strategy now is covered straddle:


Note: I used bid prices to record sales of options

In essence, by selling a straddle you can receive about $2 per share is proceeds (the minimum amount is 100 shares, which is one options contract). This translates into about a 14% return over a three-week period. The risk-return matrix for this trade is given below:


The above illustration shows that this trade is heavily biased towards the upside. Ideally, with this trade we want the stock to stay the same level as it is today when the options expire, so that we can fully capture their time value (the chart does not reflect it but the  upside return is limited to $200 per contract). The break-even price is $13 per share. If you are in the stock for a long time, you probably do not care about downside risk in the short-term. What matters to you is likely the business's fundamentals going forward.  

If you want to capitalize on this trade and also hedge your downside in the short-term, go ahead and buy two puts with a strike of $13 per share. The cost of one option is $0.85 per share, which makes the fully hedged position cost $1.7 per share. This turns the trade's profitability down to 2%, which, although on an annualized basis is high, is really negligible in absolute terms. 

What you can do in this case is cut your downside risk in half in order to save money - to hedge the short put's exposure - , while also keeping the downside risk on the stock. This will only cost you $0.85 per share, which cuts the expected return down to 8.2%. With this strategy, your downside is limited to the maximum loss in the underlying, which is $14 per share, or a 100% loss. Of course, there is no reason to believe that the company is not a going concern in the near future, at least for the duration of the trade. 

In either of these cases, the expected return is pretty high. Although the 14% trade is more attractive, I am thinking about going with the 8.2% trade because it is more beneficial from the value-at-risk's point of view.

What do you think of this trade?