RIMM Earnings Bomb: A Lesson in Options for Risk Management

When I looked two weeks ago at the rise of Research in Motion Limited (RIMM) shares above $80, I suggested long call options as the best way to play an upside breakout above $86 in the one big tech company that seemed to lag the performance of leaders like Google, Apple, and IBM. Here were the different “stock substitution” ideas I saw that investors could use to approach RIMM, based on their individual risk tolerance, all with a 120-day timeframe:

RIMM bullish call plays posted on Sep 18th:

• Aggressive – Jan 2010 80 call for $11.30, or Jan 90 call for $6.80
• Moderate risk– Jan 80/90 call spread for $4.50
• Conservative – Jan 75/80 call spread for $3

The key with all of these plays is their limited risk, and the fact that this limited risk would cause them all to perform better than buying the shares above $80. So when RIMM beat its EPS consensus but reported weaker revenue and guided lower last Thursday after the market close (causing the stock to gap down 15% the next day), long call or spread players did not suffer as much as long stock holders.

Time will tell how any of these now out-of-the-money calls will fare by January expiration to recover their losses or even turn a profit. The most conservative strategy, the Jan 75/80 bull call spread for a $3 debit, has the closest break-even at $78. RIMM is currently trading at $66.76.

But the lessons here are how “surprising” a company event can be to your portfolio and how much sleep-at-night control you can buy with options to deal with those surprises. When you went to bed Thursday night with the long calls losing value, you didn’t worry or wonder how low RIMM was going to fall and if you should sell the stock the next morning.

On the other side of the risk management coin, my partner here at ONN, Jared Levy, recommended a collar protection strategy for owners of the stock going into the RIMM announcement and those who followed his ideas were probably very glad they did. From Jared’s column mid-afternoon the day prior:

“A strategy to examine here might be to sell the October 95 Call for $4.00 and buy the October 80 Put for $2.35, yielding a $1.65 credit to you.”

With RIMM trading to a 52-week high that day above $88, Jared spotted this unusual “volatility skew” in the options, which made calls more expensive than equally out-of-the-money (OTM) puts. This was likely due to the fact that investors were coming into the options markets and consistently bidding for OTM calls, at the expense of puts, and driving their premiums higher.

Also last Wednesday, I showed a volatility chart in the OptionsNews morning report displaying the big gap between recent historical and implied volatility (the volatility implied by option prices). With 30-day historical volatility near 30%, at-the-money implied volatilities were trading over 55%. This “picture worth 1,000 words” also told the tale of option players “paying up” for further upside (and for protection) in RIMM while the stock only drifted quietly higher.

Regardless of volatility considerations, the main lesson here again is that options, whether for stock protection or stock substitution, are often the most cost-effective way to gain leverage and limit risk. We can’t always be right about direction, but we can be precise about our exposure to the move when it comes.

"Mind the risk, bank the profits!"