A brief history/geography lesson on the Outer Banks. A famous vacation spot, The Outer Banks is a thin (usually less than 1/2 mile wide) barrier island separating the Atlantic Ocean from Pamlico Sound and mainland North Carolina. It has been the scene of many vicious storms in the past; an 1846 hurricane opened , which is now the site of a 2-1/2 mile long bridge:
"Whoa!" you may say. A storm did that! Unbelievable! I would never build a nice house there. And for many years, people didn't. Here's a typical 1960's-era cottage:
Nice! Small but comfortable, close to nature, and no big deal if it gets washed away. But, as usual, people forgot how powerful Mother Nature can be, and she fortuitously chose to ignore the Outer Banks. By the 2000's, people were building homes like this:
Ridiculous! Talk about hubris! Or maybe stupidity. Needless to say, if Hurricane Irene is anything like the 1846 storm, this million-dollar home will be reduced to splinters.
Anyway, Irene is currently headed directly for the Outer Banks. After that, it's projected to roll through the heavily-populated Northeast USA, from Washington to Boston. Damage is projected to reach the billions. And when residents wake up Monday morning, and start repairing windows, doors, shingles, and possibly rebuilding homes, where will they start? Yup, Home Depot.
Of course, if I know this so does every wit and half-wit with a brokerage account. Consequently, as the storm track has crystallized, HD stock has been ramping up. It is currently trading at 34.15, up 7% from last Friday's close at 31.88. Here's the kicker: since Irene's full thrust will be felt mostly tonight and this weekend, the ultimate damage will be done while the market is closed. This means that a nimble options trader can profit a bit more from a post-storm "sell the news" move in HD.
HD's historical volatility is about 32%. September around-the-money options are trading at implied volatilities from the high-30s to nearly 50 (Sept 30 Puts). The smart(?) guys are betting on the weather! I expect implied volatility to collapse back to it's long term average on Monday. So the play today is to sell volatility. Here are a few possible strategies.
For long-term HD shareholders: Sell out-of-the-money calls, like the Sept 35 Calls for .70. By selling out-of-the-moneys, you won't run afoul of the IRS and won't owe any taxes on the underlying shares unless they're exercised. If they're called away, you'll have benefited from this week's 7% gain, plus .85 appreciation (2.5%), plus .70 options premium (2%). Total profit since last Friday: 11.5%. Profit from today: 4.5%. Not bad in a low-return world. You can also buy back the calls on Monday, after volatility collapses, if you're married to the stock.
For short-term HD shareholders: Sell slightly in-the-money calls, like the Sept 33 Calls for 1.85. This gives you a .70 (2%) premium in a pretty sleepy stock, and it can drop nearly 4% before your protection runs out. Of course, you're giving up any upside if Irene is even worse than expected, and HD adds to it's already impressive run. Still, you will benefit from collapsing IV.
For non-directional options traders: Sell high-IV options, and protect yourself with lower IV options. For example, sell the Sept 30 Puts for .27 (IV=50%) and buy the Nov 30 Puts for .97 (IV=40%) for a net debit of .70. Cover early next week for a small profit as IV collapses. Even bigger bump if HD fades.
For bullish options traders: Sell high-IV puts. For example, sell the Sept 32 Puts for .54 (IV=41%). If HD rallies next week, pocket the .54. If it drops, you can buy it 9.4% cheaper if it falls through 32 (your breakeven is 31.46, 10% below today's price). Don't be afraid of selling naked puts! It's a very conservative strategy; Warren Buffet uses it to buy companies he likes at a discount, and generate income to boot.
For bearish options traders: Sell high-IV calls, like the Sept 33 Calls for 1.80 (IV=38%). If HD drops next week, pocket the .65 risk premium, plus whatever the drop is, to a max profit of 1.80 at 33 or below. If it rallies into expiration, your effective short price is 2% higher than today's price.
(Updated 1:30pm; just thought of another one)
For neutral options traders: Sell at-the-money puts and calls. Sell Sept 34 puts for 1.10, Sell Sept 34 calls for 1.13. (HD now at 34.30). Trade is a winner if HD closes between 31.77 and 36.23 on 9/16. Or, exit the trade early next week. Seems like a nice risk/reward here as premium covers +/-6.5% move in 3 weeks.
Note that the "wise guys" are betting on a post-Irene drop, as IVs are higher on the put side than on the call side. They're expecting a "sell the news" reaction early next week, regardless of Irene's ultimate damage. Whatever you do, don't buy options outright in this environment! You could easily be right on HD's direction, and still lose money to collapsing volatility!
Also, stick to the more liquid strikes/expirations, as volume is likely to dry up post-Irene and you may be stuck having to leg out of a multi-leg option into an illiquid market...another good way to turn a winner into a loser!
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