Options Update: Electronic Arts Inc. Hit with Heavy Put Volume Following Earnings Warning

Shares of Electronic Arts Inc.
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are getting pounded today, after the company reported last night that it expects fiscal 2009 net revenue and earnings per share to arrive below prior guidance due to lower than expected sales in North America and Europe.

“The company is continuing to pursue cost saving initiatives including a reduction of its product portfolio for fiscal year 2010 with additional associated headcount reductions and facility consolidations,” Electronic Arts said in a statement.

Ahead of the open this morning, analysts were stampeding for the exits on ERTS. No less than 5 brokerage firms downgraded the shares, while 3 cut their price targets on the equity. Barron’s “Tech Trader Daily” blog has a rather in-depth rundown of the deluge of negative broker comments, with Piper Jaffray pulling a mea culpa on its “buy” rating on the stock. “We apologize for being wrong on the EA story and late to admit that this is a broken story,” said Piper Jaffray analyst Anthony Gikas, who cut ERTS to “neutral” from “buy” and slashed his price target to $18 from $38 per share.

Heading into the announcement, options traders were excessively bullish toward ERTS. The stock’s Schaeffer’s put/call open interest ratio (SOIR) of 0.30 indicates that calls more than triple puts among near-term options. Furthermore, this ratio ranks below 98% of all those taken during the past year, hinting at an extreme degree of optimism from this speculative bunch.

Elsewhere, data from the International Securities Exchange (ISE) and Chicago Board Options Exchange (CBOE) reveals a 10-day put/call ratio of 0.96. While the reading indicates that calls bought to open outnumbered puts bought to open during the prior 10 days, this ratio ranks above 72% of all those taken during the past year, hinting that ERTS was beginning to fall out of favor with options traders.

Today’s activity in the options pits underscores this fall from grace, as put volume has outstripped the stock’s daily average by a ratio of more than 13 to 1. Looking at our Intraday Volume Explosion List, I noticed that the most active contract was the December 15 strike, which has seen more than 13,000 puts change hands so far today.

Electronic Arts option volume details

The Anatomy of a Electronic Arts Put Position

Digging into this put activity, I noticed that 1 block of 300 contracts changed hands at 11:22 a.m. Eastern time at the ask price of $0.55. The total outlay for this position would be $16,500 — ($0.55 * 100)*300 = $16,500. For this trade to reach breakeven, ERTS would need to fall about 25% to $14.45 per share from yesterday’s close of $19.35 per share before the options expire on December 19. The maximum loss on this position is limited to the initial investment of $16,500.

By entering this trade, the investor is indicating that he expects ERTS to decline rapidly the next 2 weeks. The shares have fallen more than 14% so far this afternoon, starting this position off on the right foot. That said, let’s see if the stock’s technical or sentiment backdrops provide any additional drivers for this trade.

Getting Technical

Technically speaking, ERTS is primed for a continued trend lower. The equity has plunged more than 66% since the beginning of the year, easily outpacing the S&P 500 Index’s (SPX) loss or about 39% for the same time frame. Furthermore, ERTS has been pressured lower by its 10-week moving average since late August. Today, the shares broke below potential short-term support at the 17 level – an area that provided a backstop for ERTS in late November. What’s more, this sharp decline has pulled the security’s 10-day and 20-day trendlines into a bearish cross. This latter technical formation could signal that ERTS has further to fall before selling pressure is exhausted, potentially providing a nice return for a purchased December 15 put.

Daily chart of Electronic Arts since September 2008 with 10-day and 20-day moving averages

The Sentiment Drivers

As mentioned above, we are seeing a bit of a sentiment shift among options traders, according to data from the ISE and the CBOE. The same could be said for the brokerage bunch, as Zacks.com reports that, prior to this morning’s wave of downgrades, 8 of the 14 analysts following ERTS rated the stock a “buy” or better. Furthermore, Thomson Financial states that the average 12-month price target for the shares rests at $37.34 – a 92% premium to the equity’s Tuesday close. Any additional downgrades or price-target cuts from the analyst community could extend ERTS technical woes even further.

Sentiment indicators for Electronic Arts

The Verdict?

An out of the money put position is a little too aggressive for my tastes, but I like the idea of buying puts on ERTS to take advantage of an extended decline in the shares. Instead of a December 15 put, traders might consider a January 2009 17.50 (or 20) put. The ask price for a January 2009 17.50 put currently rests at $2.50, meaning that ERTS would need to fall about 22% to $15 per share from yesterday’s close. Currently, the stock is hovering just above the 16.50 level, making this trade much more attractive.

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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.