How I Strangled 120% Out of HP

By Mohamed Mounir - September 25, 2012 | Tickers: DELL, HPQ | 0 Comments

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Hewlett Packard (NYSE: HPQ) and Dell (NASDAQ: DELL) have been two stocks that I had my eye on these past few months. The two tech giants are struggling to find their place in a post PC world.  They have been trading at depressed valuations and have witnessed quite a bit of volatility on their earning releases, usually to the downside. 

Last August the 22nd, the day HP was reporting earnings, I decided to use an options strategy called a long strangle to take advantage of any volatility after HP's earnings announcement. The return was a whopping 120% in two days.  

First lets discuss the basics and then i'll get in to why I made the trade

If you can't tell the difference between a lot and the Lotto 649, you might want to take a look here first.

Full disclosure: I still don't use real money in options trading I was using an options simulator that tracks real life prices and volumes.

The Long Strangle

A Long Strangle is an options strategy where you hold a position in both a call and put with different strike prices but with the same maturity and underlying asset. This option strategy becomes profitable only if there are large movements in the price of the underlying asset.  

So mainly you're banking on Volatility not direction. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be.

Note that a Long Strangle simply means that you are buying the puts and calls and a Short Strangle means you are selling the puts and calls, it has nothing to do with being bullish or bearish. 

This is what the profit loss chart looks like

The Trade

It was Wednesday the 22nd of August 2012, Dell had just reported earnings 24 hours prior. The results were not so great. Revenue was down 8% and Net Income fell by 18%. Dell lowered guidance for the rest of the year due to lagging PC sales. The stock tanked 4.54%  in after hours trading. This was followed by another 7% decline the following day. That was more than a 10% two day decline for a stock that was already trading at anemic levels.

HP was getting ready to announce earnings on the day of the trade a mere 24 hours after Dell.  HP's business has alot of similarities with Dell. Not only that, but their stock performance has also been more or less the same. It looked to me that HP and Dell were together in the same boat.

DELL data by YCharts

 Usually if a company does very lousy on an earnings release it can announce a restructuring and downsizing move and the market will cut it some slack, but HP had already done that last quarter so it didn't have that weapon in its arsenal. 

I decided to place a Long Strangle on HP, but slightly different than the one described above. I used a Long Strangle with a bearish sentiment, meaning than I bought twice the number of puts as I did the number of calls. Basically I was looking to profit if the stock plunged, and break even if HP posted better than expected results and the stock surged.

HP was trading at $19.38 when I made the trade

I bought

20 put lots* strike price 19 Expiration August the 24th trading at $0.33 per share

10 call lots* strike price 20 Expiration August the 24th trading at $0.40 per share

*lot is 100 shares

Sure enough HP reported earnings. HP lowered guidance for Q4 as Dell had done. HP also had to do a massive impairment charge of $8 billion due to the acquisition of EDS that didn't produce the expected value. The result was an $8.9 Billion loss, the largest loss ever in the company's history.  The stock plunged below my put's strike price of $19 hitting a low of $17.50 two days later. The value of my put reached $1.36 on the 24th of August.

The Return 

Initial investment: $854.99+ $367.49 = $1222.48

Return = $2665.01- $1222.48 = $1442.52

ROI= $1442.52/$1222.48 = 118% 

Disclosure: Options Trading carries a high degree of risk. If HP's price had remained in between $19 and $20, I would have lost 100%!

Foolish Bottom line:

Options trading with a strong fundamental outlook can lead to out-sized returns. Last year the I believe the Motley Fool gave free access to Options Whiz which is the Motley Fool's proprietary options U during December. I didn't really pay attention to it at the time, but this year if they do give access to it again I will be sure to make use of it, or maybe purchase it if I can afford to.

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