Options Update: Is DR Horton’s Unusual Put Volume a Play on Earnings?

According to the company’s website, DR Horton
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is slated to release its fourth-quarter earnings figures on November 25. Currently, analysts are looking for a loss of 69 cents per share, down sharply from last year’s loss of 16 cents per share. Historically, DHI has struggled in the earnings confessional, matching Wall Street’s expectations twice and missing twice for an average miss of 116% for the past 4 reporting periods.

Despite the report being more than a month away, it would seem that options traders are already positioning themselves ahead of the event. Before midday, more than 8,000 puts had changed hands at DHI’s November 7.50 put, while another 10,000 had traded at the stock’s January 2009 7.50 put. The attention was enough to place DHI on our Intraday Volume Explosion List.

DR Horton option volume details

Digging into the volume, I found 2 block trades that appeared to be related, as they crossed on the same exchange at about the same time. Specifically, a block of 6,038 November 7.50 puts traded at $0.75, within 5 cents of the bid price at the time – suggesting that the contracts were sold. Meanwhile, a block of 8,538 January 2009 7.50 puts crossed the tape at the ask price of $1.30 – suggesting that the contracts were purchased.

Anatomy of a DR Horton Put Position

Why would this activity be related to the company’s earnings report on November 25? Because November options expire on 21st, 4 days ahead of DHI’s earnings report. Assuming that these 2 block trades are related, there are 2 potential strategies that could explain today’s volume. The first, and most simple, explanation is that the trader is rolling out the November 7.50 put position into January in order to take advantage of a potential negative reaction to DHI’s earnings report. By selling (to close) the 6,032 November 7.50 puts and buying the January 2009 7.50 puts, the trader places the expiration of the position after the event with enough time premium to cushion the blow should DHI exceed expectations.

The second explanation is a bit more involved. Assuming that the trader is opening a fresh position on both the November and January 2009 options, it would appear that he is expecting DHI to hold above 7.50 through November 21 (when the options expire), but anticipates a negative reaction to the company’s earnings report. Specifically, the trader sold 6,038 November 7.50 puts at $0.75 or a total credit of $452,850 — ($0.75 * 100)*6,038 = $452,850. Meanwhile, the trader also bought 8,538 DHI January 2009 7.50 puts for a total outlay of $1,109,940 — ($1.30 * 100)*8,538 = $1,109,940. The total cost (or debit) for the combined positions arrives at $657,090 — $1,109,940 – $452,850 – $657,090.

So, how does the trader make a profit on this unusual trade? Optimally, he needs DHI to hold above the 7.50 level through November 21, with the shares plunging before the second half of the trade expires on January 16, 2009. For the second half of the trade to reach breakeven, the trader needs DHI to fall to $6.95 per share (roughly 28% from yesterday’s close). We arrive at this figure by subtracting the difference between the sold and purchased put options ($1.30 – $0.75 = $0.55) from the strike of the purchased put ($7.50 – $0.55 = $6.95).

Now that we have the 2 possible explanations for today’s unusual put volume out of the way, let’s see if the stock’s technical picture or sentiment backdrop provide any clues on the potential outcome for a put position on DHI.

Getting Technical

From a technical perspective, DHI has taken quite a beating so far in 2008. The shares are off more than 26% since January, and have plunged more than 40% since setting a near-term peak on September 19. However, the stock has outpaced overhead resistance at its declining 10-week and 20-week moving averages. Furthermore, the shares appear to have found support in the 9 region – site of the stock’s late-July lows. With potential technical support just below the equity, and plenty of room between DHI and pressure from its intermediate-term trendlines, the prospects of the shares holding above the 7.50 level through November options expiration look promising.

Weekly chart of DR Horton since January 2008 with 10-week and 20-week moving averages

The Sentiment Drivers

The sentiment backdrop for DHI, meanwhile, is a double-edged sword for the November/January 2009 7.50 put position outlined above. Falling in line with the stock’s poor technical performance, DHI investors are extremely bearish toward the equity. Specifically, the stock’s Schaeffer’s put/call open interest ratio (SOIR) of 1.74 ranks above 94% of all those taken during the past year, indicating that options traders have been more negative toward the shares only 6% of the time in the past year. In terms of today’s trading example, an unwinding of this negativity (however unlikely given DHI’s poor price action) could provide support for the sold November 7.50 put. Of course, such an influx of buying pressure would work against the January 2009 7.50, but this latter half of the trade seems designed to take advantage of the company’s earnings report.

As for the impact of analyst ratings on the position, we have room for movement in either direction. According to Zacks.com, the brokerage bunch has a bearish slant, with DHI earning 3 “buys,” 3 “holds,” and 2 “sells.” On 1 hand, the combination of the stock’s negative price action and the potential for an earnings miss on November 25 creates the possibility of downgrades from the remaining DHI bulls. On the other hand, a rebound from technical support or an earnings surprise to the upside could elicit a few upgrades from the bearish majority.

Sentiment indicators for DR Horton

The Verdict?

While a bit convoluted, the combination of a sold November 7.50 put and a purchased January 2009 7.50 put does have a bit of merit. The main benefit is that by selling the November put, the trader offsets the cost of the January 2009 put, thus lowering breakeven on the position (assuming DHI holds above 7.50 through November). Under this assumption, this trade clearly benefits from further deterioration in the credit and housing markets and from a poor earnings performance from the company on November 25.

However, the sold November 7.50 put is almost counterproductive to the overall position due to the costs involved should it move into the money. As such, this is not a strategy that I would recommend, as there are better ways to hedge a bearish play on DHI’s earnings report. Ultimately, the K.I.S.S. (keep it simple silly) methodology is the best approach when trading ahead of an event or when analyzing option activity.

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