Options: Avon Shows Power of Leverage

Why you don't need to wait for expiration to make money.
Publish date:

By Jud Pyle, CFA, chief investment strategist for the Options News Network

Shares of

Avon Products

(AVP) - Get Report

have sold off more than 9% on news that

Estee Lauder

(EL) - Get Report

has cut its earnings and sales outlooks for the fiscal second quarter and year.

Avon and Estee Lauder compete in the same space, so people figure if things are bad for Estee Lauder, they must be bad for Avon as well. From an option perspective, what is interesting about this move in that a little over a week ago, on Jan. 7,

I wrote about unusual put-option activity in Avon that would profit from a move just like this

. Let's recap and see how that trade has worked so far.

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On Jan. 7, I pointed out that an investor had purchased over 18,000 of the February 17.5 puts vs. an open interest at the time of around 120. The investor paid 35 cents for those puts, when the stock was trading around $24.30. Now with the stock down closer to $20, those puts are trading higher than 80 cents.

I said at the time that an investor did not have to wait until expiration to make money, and this is a classic example. The put-buyer has a greater than 128% return on the initial 35-cent bet, yet the stock is still nearly $3 above the original break-even point.

The other put option that we covered on Jan. 7 was the Feb. 20 puts. An investor -- probably the same one -- bought these puts over 10,000 times for around 60 cents. That put is now trading for over $1.80. So that is a greater than 200% return, even though the intrinsic value of the option is still less than the original premium the investor paid for it.

This little recap demonstrates the power of leverage in options when an investor is right. The fact that the option still has time value left means the investor has made money without the stock getting to the break-even level needed. The old cliché is that smart money often uses options to make their bets. In the case of Avon, that would seem to be the case.

Jud Pyle is the chief investment strategist for Options News Network and the portfolio manager of TheStreet.com Options Alerts. Click here for a free trial for Options Alerts. Mr. Pyle writes regularly about options investing for TheStreet.com.

Jud Pyle, CFA, is the chief investment strategist for Options News Network. Pyle started his career in finance in 1994 as a derivative analyst with SBC Warburg. After four years with Warburg, Pyle joined PEAK6 Investments, L.P., in 1998 as an equity options trader and as chief risk officer. A native of Minneapolis, Pyle received his bachelor's degree in economics and history from Colgate University in 1994. As a trader, Pyle traded on average over 5,000 contracts per day, and over 1.2 million contracts per year. He also built the stock group for all PEAK6 Investments, L.P. hedging, which currently trades on average over 5 million shares per day, and over 1 billion shares per year. Further, from 2004-06, he managed the trading and risk management for PEAK6 Investments L.P.'s lead market-maker operation on the former PCX exchange, which traded more than 10,000 contracts per day. Pyle is the "Mad About Options" resident expert. He is also a regular contributor to "Options Physics."