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I Am Short The Gap's Volatility Pre-Earnings

The Gap, Inc. (GPS) is an apparel retail company. The company offers apparel, accessories and personal care products for men, women and children under the Gap, Banana Republic, Old Navy, Athleta and Intermix brands. Its products are available to customers online through company-owned websites and through the use of third-parties that provide logistics and fulfillment services. It also sells products that are designed and manufactured by branded third-parties, especially at its Intermix brands. It is reporting earnings on Thursday, August 18, after market close:

(Source: TD Waterhouse)

As evident from the above, the company beat earnings estimates in 37% of time in the last eight quarters, showing in-line results in the rest of time, and has seen modest volatility in the market price of its stock over the last three months:

The market participants expect the following numbers over the next few quarters, including the upcoming one:

(Source: TD Waterhouse)

Market data show that the August options are a bit overvalued:

(Source: TD Waterhouse)

The two-day straddles (options with a strike price of $25.50 and expiring on August 19, 2016) are worth around 5.5% of the current market price of the stock. Historically, the stock has been more volatile than that on a monthly basis over the last year:

(Source: Google Finance. Calculations by author)

As you can see, the stock has had a monthly standard deviation of 11.6% over the last 52 weeks, while the straddle expiring in two days has an implied monthly volatility of around 3.6% (calculated based on 2 business days remaining until expiration), also including volatility from the earnings event this week. I therefore see signs of modest overvaluation in these options. Hence, selling the straddles is a good idea from a theoretical standpoint.

Investors may also be interested in selling calendar spreads to capitalize on the higher implied volatility of the front month's options:


The risk-return profile of this trade looks like this:


As you can see from the above illustration, the "window of safety" is around 13.4%. This means that the stock has to move roughly 7% in either direction from the current price by expiration in order for investors to start losing money. The risk-reward ratio of around 1:1.43 is below-average with this type of option strategies and is deemed attractive in the case of a relatively low volatility stock like The Gap Inc. 

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