Tim Hortons Serves Up Some Unusual Activity

On Wednesday October 9th, Tim Hortons (TSE:THI) caught my eye as one of the most active option series trading on the Montreal Exchange. As I cautioned in my previous blog entitled Interpreting Unusual Options Activity this is not a mechanism for establishing a directional bias, however, it can be a starting point for uncovering a trade idea.

You can review historical data on any option chain by selecting the symbol, accessing the chain and then selecting Trading » Reports » Historical Data. Below is a snap shot of the closing numbers on the aforementioned date:

A quick look at the chain reveals a large number of transactions at the November 62 and 64 calls, as well as the November 56 and 54 puts. Once again, we cannot determine if these transactions were buys or sells or if they were all part of the same strategy, so it is very much open to interpretation. Further investigation reveals that Tim Hortons is scheduled to release earnings on November 7th. With the November contracts expiration date falling on the 15th, it is entirely possible that these options were selected as part of an earnings play.

There are a number of strategies that one might consider around an earnings report. If an investor owns the stock, Protective Puts may be purchased to protect the downside risk. A Collar may be implemented by selling calls above the current price leaving some upside on the stock while using the premium to offset the cost of the puts. In addition, during uncertain events such as earnings, a Straddle or a Strangle may be applied. This strategy involves the simultaneous purchase of calls and puts with the expectation of a large move up or down in share price. The challenge with a Straddle or Strangle purchase preceeding an earnings report is insuring that you are not overpaying for the options due to an expansion of implied volatility. When we look at the option chain above, we can see that the historical volatility of the stock sits at 6.3% while the implied volatility of the calls and the puts hightlighted range from 19 to 21%. This places the Straddle or Strangle buyer at risk of a volatility contraction if the impact of the earnings report is not sufficient to compensate for increased implied volatility. In other words, the stock could move, but not enough to profit as the news is revealed and implied volatility contracts.

The way that the volatility risk can be offset is by creating strategies that combine both buying and selling option contracts. Assuming the large majority of the contracts traded are all part of the same strategy, a bullish investor could favour the upside of the stock by creating a Bull Call Debit Spread.

With the shares at $59.70, this would involve the following:

• Buy the November 62 strike calls and pay $0.65
• Sell the November 64 strike calls and collect $0.28
• Net debit = $0.37
• Max profit = $1.63 ($2.00 spread minus the premium)
• Break even on expiration = shares at $62.37

Assuming 2000 spreads were executed, this would be a cost of $74,000.00 for a profit potential of $326,000.00

If the investor wished to reduce the cost basis even further, a Bull Put Credit Spread could be executed below a price point where the stock wasn’t expected to fall. By executing fewer credit spreads than debit spreads, the investor limits the amount of additional risk added, but still benifits from the collection of additional premium.

The Bull Put Spread would involve the following:

• Sell the November 56 strike puts and collect $0.35
• Buy the November 54 strike puts and pay $0.19
• Net credit = $0.16
• Max Risk = $1.84 ($2.00 spread minus the premium collected)
• Break even on expiration = shares at $55.84 (56 strike minus premium collected)

Assuming that 500 spreads were executed, a credit would be received of $8000.00, but an additional risk of $92,000.00 is added.

All things considered:

The cost of the combination would be the $74,000.00 debit – $8000.00 credit = $66,000.00

The risk is increased due to the Credit Spread and is determined to be:

$74,000.00 ( debit)
+ $ 92,000.00 (credit spread differential minus credit)
= $166,000.00

This would be incurred if the shares are below $54.00 on expiration.

So, we can assume that the maximum risk on the trade is $166,000.00 for a maximum profit potential of $326,000.00

The ideal scenario

The ideal scenario for the investor is when the shares are trading above $64.00 on expiration. The full profit on the Bull Call Debit Spread will be realized and full profit on the Bear Put Credit Spread will be realized as the options expire worthlessly out of the money.

And now the waiting game

If the objective of this hypothetical trader was to create an asymetrical risk/reward opportunity by insuring a greater profit potential than risk exposure, then the mission has been accomplished. As of this writing, shares of Tim Horton’s closed at $60.49, a move in favour of this strategy. That being said, a strategy like this needs time to play out as the assumption is made that the strategy is based on a positive earnings report. We will revisit the strategy post earnings to reveal how this hypothetical trade plays out.