Sell Ross Stores` Overvalued Options Pre-Earnings
Ross Stores, Inc. (ROST) is an off-price retailer of name brand and designer apparel, accessories, footwear, and home fashions for the entire family. The company and its subsidiaries operate two brands of off-price retail apparel and home fashion stores: Ross Dress for Less (Ross) and dd's DISCOUNTS. Ross is an off-price apparel and home fashion chain in the United States, with approximately 1,274 locations in over 34 states, the District of Columbia and Guam. Ross' target customers are primarily from middle income households.). It is reporting earnings on Thursday, August 18, after market close:
As evident from the above, the company beat earnings estimates in 50% of time in the last eight quarters, underperforming or 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 month:
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 one-week straddles (options with a strike price of $62.50 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 8.2% over the last 52 weeks, while the straddle expiring in a few days has an implied monthly volatility of around 2.5% (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 iron condors to capitalize on the above-average implied volatility, while hedging against swift moves in the underlying:
The risk-return profile of this trade looks like this:
As you can see from the above illustration, the "window of safety" is around 10.7%. This means that the stock has to move roughly 5.5% in either direction from the current price by expiration in order for investors to start losing money. The risk-reward ratio of around 1:0.38 is in line with this type of option strategies and is deemed attractive in the case of a low volatility stock like Ross Stores.