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Lower Volatility Bet on CVS

Jud Pyle CFA

CHICAGO (TheStreet) -- CVS Caremark(CVS) is seeing investors bet on decreased volatility a day after the pharmaceutical retailer announced earnings.

The company said third-quarter earnings on Thursday came in at 65 cents per share, a penny better than estimates. Revenue was in line with analysts' expectations as well.

In other news, CVS announced that its board approved a new share repurchase program for up to $2 billion of its outstanding common stock. But news that the company was lowering its guidance for the PBM (pharmacy benefit) business sent the bears into action and before the closing bell mercifully sounded. CVS was off 20%.

The hype surrounding earnings ran up implied volatility on CVS to 39%, compared to week-ago levels of about 29%. With the news now out of the way, implieds are getting crushed. One way to gauge this is by looking at the front-month, at-the-money straddle.

On Wednesday night, this spread was priced at $2.15, or 7.5% over strike (investors who bought this straddle, expecting more volatility, made a nice profit!). By Thursday's close, the straddle had dropped to $1.77. Today so far, it dropped further to $1.55. In other words, the options market expects a move of 5.2% in the stock during the next two weeks before November options expire.

Today, an investor sold the December 30 straddle 5,500 times, collecting $2.81 per straddle. Blocks traded at 12:09 p.m. EDT, with the December 30 put being sold for $1.70 and the December 30 call selling for $1.11.

Heading into today, the call was home to 2,530 contracts in open interest and the put was home to just five contracts. Therefore, these straddles were sold to open. At the time of the transaction, CVS shares were up 48 cents at $29.35.

Risk in this trade is unlimited, but straddle sellers bank on time decay and decreasing volatility as the expiration month approaches following a potential dramatic move in the underlying. Maximum profit is the credit collected -- $2.81-- and occurs CVS closes exactly at 30 at December expiration. For CVS to hit the 30 mark exactly, it needs to rise 1.4% in the next six weeks.

Maximum potential loss is theoretically unlimited to the upside and capped at $27.19 (the strike price minus the net credit) to the downside.

-- Written by Jud Pyle in Chicago