This column was originally published on RealMoney on Nov. 16 at 2:00 p.m. EST. It's being republished as a bonus for TheStreet.com readers.

Reader Tradezzup asks, "Assuming a bullish stance on

Sears

(SHLD)

and given today's action, do you care to offer a simple options strategy that would take advantage of this drop and assumes a rebound over the next month or so?"

Shares of Sears are trading down about $9, or 5%, following its

earnings report. I won't pretend to know whether the numbers or the reaction creates a buying opportunity. But as an options trader, the one thing I know for sure is that after the earnings report, the implied volatility of the options is down some 5%. It's likely to drift lower in the next few days, as the stock digests the news and tries to find some support and establish a new trading range.

At the moment, it looks like the stock might need some time to repair itself. Without any immediate catalysts on the horizon, the near-term upside might be limited. That means taking a patient approach.

The most basic, straightforward approach would simply be to buy call options for establishing a bullish position. It would make sense to buy call options that have at least 60 days remaining until expiration and to build the position by scaling in over time, price or both in order to achieve an attractive average purchase price.

A patient approach can also be bought through the purchase of a calendar spread. That is selling a near-term call premium and simultaneously buying a longer-term call option. My choice would be to use a slightly out-of-the-money calendar-spread strategy, such as selling the December $175 calls and buying the March $175 calls for a net debit of $7 for the spread Some of the advantages of this position include the following:

  • The sale of the near-term options will mitigate the negative impact of time decay, as the theta of the short option will accelerate as its expiration approaches. Also, the upcoming Thanksgiving holiday will have the effect of removing trading days or dialing the forward the calendar, making December options a short expiration cycle. If shares of Sears can stay above $170 but below $175 for the next few weeks, the December options will expire worthless, while the value of the March options will only lose a small amount of time premium. Assuming all else remains the same, if shares of Sears are at $170 on the Dec. 15 expiration, the March $175 calls will still be worth around $11 per contract. A flat stock price can result in a $4 profit over next 30 days. This type of position will become more bullish over time, so the best-case scenario is for Sears to work higher and be at the $175 strike price on the December expiration.
  • The general pattern is that IV peaks on the day before an earnings report and then troughs in the next two weeks. As a net debit position, a long calendar spread benefits from an increase in implied volatility, which I expect to start trending higher at the end of December and beginning of January as holiday sales numbers are reported. This position offers the flexibility of rolling the short December calls into January to further reduce the effective cost basis of the long March call options. The March options should hold their premium and should still be alive ahead of the company's next earnings report.

The scenario that would negatively impact a long calendar spread is a sharp price move in either direction. As a net bullish position done for a net debit, a decline in price will cause a decline in the value of the spread. A dramatic price increase, in which the strikes get pushed into the money, can also result in a loss, as the option prices will basically be made up of intrinsic value causing the value of the spread to flatten or decline.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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