Options Update: Straddling Hewlett-Packard (HPQ) Ahead of Earnings

Dow Jones Industrial Average (DJIA) component Hewlett-Packard
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HPQ |
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is slated to release its third-quarter earnings report after the close tomorrow night, and the options pits are jumping with speculation today. For the record, HPQ is expected to earn 83 cents per share for the quarter, a 16.9% increase over the same period last year. Furthermore, the company has been a solid performer in the earnings confessional, besting the consensus estimate in each of the past 4 reporting periods by an average of 5.6%.

Turning our attention to the options pits, puts and calls are both receiving heavy attention the day before HPQ offers up its earnings figures. Specifically, more than 12,800 puts have crossed the tape, while some 16,000 calls have changed hands – both figures more than triple their respective daily trading averages. This heavy across-the-board volume has placed HPQ on our Intraday Volume Explosion List. However, it was the potential for a straddle position at the September 45 strike ahead of the company’s earnings report that caught my eye today.

Straddling Hewlett-Packard

Digging into the activity, I discovered that a block of 606 HPQ September 45 puts (HPQ UI) traded at 10:23 a.m. Eastern – crossing at the price of $1.78. At the same time, a block of 606 HPQ September 45 calls (HPQ II) changed hands at the price of $1.67. Given that the trades went off at the same time and are of the same size, we are most likely looking at a September straddle for HPQ. (For reference, a straddle is the simultaneous purchase or sale of an equal number of puts and calls on a given underlying stock with the same expiration date and strike prices.)

The trade works like this: our hypothetical trader buys 606 HPQ UI contracts for $178 each ($1.78 * 100), for a total outlay of $107,868. Simultaneously, the trader buys 606 HPQ II contracts for $167 each ($1.67 * 100), for a total outlay of $101,202. The total cost of the position amounts to roughly $209,070. The idea behind this strategy is for HPQ to move sharply (the direction doesn’t matter) before the options expire on September 19.

Hewlett-Packard September 45 straddle details

For the trade to reach breakeven, HPQ must rally about 10% to $48.45 per share, or fall 5.57% to about $41.55 per share. To arrive at our breakeven target, we add the cost of both options and add/subtract that total to the purchased strikes. For instance, on the call side, we add $1.67 (the price of the call) to $1.78 (the price of the put) to arrive at 3.45. By adding this figure to 45 (the purchased call strike), we see that HPQ needs to rally to $48.45 per share in order for the trade to reach breakeven. On the put side, we’d subtract 3.45 from 45 (the purchased put strike) to arrive at a breakeven of $41.55 per share.

Technically Speaking

The technical picture for HPQ is somewhat supportive of this hypothetical straddle position. Long-term resistance for the shares rests at the round-number 50 level (just above breakeven for the trade), while long-term support for the shares rests in the 40 region (just below breakeven on the downside for the trade). That said, the technical picture seems to support the bearish side of this trade. The stock continues to fall under resistance from its 10-week and 20-week moving averages, with the latter of these capping the stock since the week of June 13. Furthermore, the 45 level (site of the straddle position) is also a long-term support/resistance level for the shares. With HPQ dropping below this level in today’s trading, we could see the stock ushered lower as selling pressure gains traction.

Weekly chart of Hewlett-Packard since April 2007 with 10-week and 20-week moving averages

The Sentiment Drivers

On the sentiment front, we have a mixed bag for HPQ. Wall Street is heavily bullish toward the company, as Zacks.com reports that 14 of the 18 analysts following the shares rate them a “buy” or better. Any downgrades from this group following a disappointing earnings report, poor guidance, or tightening gross margins could exacerbate a downside move from the shares, thus lending further support to the September 45 put purchased in the HPQ straddle.

On the other hand, expectations appear to be very low among options traders heading into the company’s report. Currently, HPQ’s Schaeffer’s put/call open interest ratio (SOIR) of 0.96 ranks at an annual peak, indicating that speculative investors have not been more negatively aligned at any point during the past year. While some of this negativity could have been exacerbated by August options expiration last week, HPQ’s SOIR was already in the 87the percentile of its annual range on Friday. Lowered expectations prior to the report could make it easier for the company to surprise investors with better-than-expected earnings figures – thus supporting the September 45 call purchased in the HPQ straddle.

Sentiment indicators for Hewlett-Packard

The Verdict?

Since there are plenty of drivers for both a bullish and bearish reaction to the company’s earnings report tomorrow night, an HPQ straddle could be just the ticket to take advantage of a big move in the shares. Given the technical and sentiment data above, the skew appears to be toward the downside for the shares at the moment, and a breach of the 41 level later this week would place our hypothetical trader in good standing. The worst-case scenario for this trade is for HPQ to find short-term support at the 42.50 level, or rally into resistance at the 45.50 level (home to the stock’s 20-week moving average).

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