Making 10% in less than a month is opportunity not presented very often. But you may find this type of opportunities at times and not a bad Idea to analyze and make use of them.
The opportunity
It seems like investors have lost confidence in the Business Model of Pandora and are dumping the stock. Pandora Media This California based company provides an Internet radio services in the United States. The company allows listeners to create up to 100 personalized stations to access unlimited hours of free music and comedy, as well as offers a paid subscription service to listeners. The segment in which the company works has low barriers to entry and it faces competition from like of SIRI and CBS Radio. The stocks plunged recently when AAPL declared that it would be starting the Internet service from 2013.(See Below)
The stocks lost more than 25% in less than a month on this news. But the people who had confidence in the Business Model of the company saw that as an opportunity and started adding that to their portfolio. The stock gained more than 25% on increasing volume (another good sign) after hitting its 52 week low in mid Nov.
Opportunity in Pandora
Pandora results are due on Dec 4th. The stock is currently trading at $9.03 as of Dec 3rd 2012. There are 3 approaches that can be followed depending on your assessment of the company.
When the results of companies are due, the implied volatility for the stock rises resulting in the exceptional rise of premium on options. This means that investors can take advantage of this scenario by making any of the below trades.
Potential Trades
Trade 1(If you are Bullish): Buy stocks of Pandora at $9.03 and sell the CALL Option for 90c for Dec 21 Strike Price of $9.
Trade 2(If you are Bearish): Short stocks of Pandora at $9.03 and sell the PUT Option for 90c for Dec 21 Strike Price of $9.
Trade 3(If you are Neutral expecting no to little movement in stock): Sell PUT and CALL Options each for 90c for Dec 21 Strike Price of $9. This Strategy is called Short Straddle.
Payout of the Trade
There are 3 different scenarios that can happen on the day of expiration on Dec 21st.
Trade 1(Covered Call). Note your Breakeven for this trade in $8.13.
- Stock price of Pandora > $9.00: The stock will be called and you will be obligated to sell the stock at the Strike Price of $9.00. You will still make 87c ($9.03(buy price) - $9(strike price) + 90c (premium)) excluding brokerage.
- Stock price of Pandora < $9.00 but >8.13: The premium will be all yours to keep and you also own the stock. If you want you can sell the stock to make profit or sell another call to get more premiums.
- Stock price of Pandora < $8.13: The premium will be all yours to keep and you also own the stock. But theoretically you have made a loss in the trade because the decline in the value of the stock is more than the premium you received to own the stock. In this situation, I recommend to keep a watch and close the covered call position when you find it useful.
Trade 2 (Short Stock and Sell PUTS). Note your Breakeven for this trade in $9.93.
- Stock price of Pandora at expiration< $9.00: You will be obligated to buy the stock at the Strike Price of $9.00. But since you have shorted the stock, you have gained on the short position of the stock. So you can buy the stock at $9 and close your position. You will still make 87c ($9.03(Short price) - $9.00(purchase/strike price) + 90c (premium)) excluding brokerage.
- Stock price of Pandora > $9.00 but <9.93: The premium will be all yours to keep. You have made loss on shorting the stock but the premium you received on selling PUTS covers some losses leaving some money for you to have fun. You can buy the stock and close the position if you want.
- Stock price of Pandora > $9.93: The trade has gone against your expectation. The premium will be all yours to keep but you have to return the stock you shorted/borrowed. Theoretically you have made a loss in the trade because the increase in the value of the stock is more than the premium you received. You should try to buy the stock and close your short position if you see the stock rising.
Trade 3 (Short STRADDLE). The closer the stock is to the strike price of $9, the higher is your profit.
- Stock price of Pandora at expiration< $7.20: The CALL you sold will end Worthless but the PUT you sold will end in the Money. You will be obligated to buy the stock at the Strike Price of $9.00 even though it is trading below $7.20. You will be suffering the loss since the premium you received can cover only a part of your loss. I recommend to short the stock if you see the stock price decreasing so that you can close the position by buying the stock.
- Stock price of Pandora > $7.20 but <9.00: The CALL you sold will end Worthless but the PUT you sold will end in the Money. You will be obligated to buy the stock at the Strike Price of $9.00 even though it is trading below $9.00. You will have some profit because the premiums you received was more than the loss you had because of purchasing the stock at higher than market price.
- Stock price of Pandora > $9.00 but <10.80: The PUT you sold will end Worthless but the CALL you sold will end in the Money. You will be obligated to sell the stock at the Strike Price of $9.00 even though it is trading above $9.00. You will have some profit because the premiums you received was more than the loss you had because of selling the stock at lower than market price.
- Stock price of Pandora > $10.80: The PUT you sold will end Worthless but the CALL you sold will end in the Money. You will be obligated to sell the stock at the Strike Price of $9.00 even though it is trading above $10.80. You will be suffering the loss since the premium you received will cover only a part of your loss. I recommend to buy the stock if you see the stock price increasing to fulfill your obligation.
My Position:
I am going with Trade 1 since I believe in the Business Model of the company and expect it to do good in the short and long term.
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