Options Update: Kroger Call Volume Jumps Ahead of Earnings

In less than 1 week, Cincinnati, Ohio-based Kroger (KR | Quote | Chart | News | PowerRating) is scheduled to release its second-quarter earnings report. Currently, analysts are looking for a profit of 41 cents per share from the grocer, a 7.8% increase over the same quarter last year. KR has been a solid performer in the earnings confessional, topping analysts' estimates in 3 of the past 4 reporting periods with an average upside surprise of 7.64%.

Options players appear to be piling into calls today ahead of next week's event, and with good reason. On June 24, KR topped Wall Street's expectations by 3 cents per share and guided higher for the full year. On the news, the shares surged more than 12% higher in the following 2 sessions, jumping from $26 per share on June 23 to $29.35 per share on June 25. The stock extended that rally to near the 30 level by mid-July, but it is the sharp 2-day move that today's options players are likely banking on.

Kroger will release its quarterly earnings report on September 16, just 3 days prior to the expiration of September options on the 19th. Today's options volume on KR is focused at the September 30 strike. Overall, more than 14,000 calls have traded on the equity so far today, outpacing KR's usual call volume by a factor of 15 and placing the stock on today's Intraday Volume Explosion List. However, nearly all of this volume is concentrated at the September 30 strike, with some 11,000 calls crossing the tape. With earnings looming on the horizon, you can bet that this speculative call activity is what caught my eye today.

Anatomy of a Kroger Call Position

Looking at the call volume above, you can see that the majority of today's trading is crossing the tape in small blocks of options, ranging between 200 and 300 contracts. This would indicate that individual traders are responsible for the volume, and not institutional investors. Furthermore, the trades are changing hands at the ask price, which suggests call-buying activity when combined with the fact that today's volume has easily outstripped open interest of just 2,573 contracts. Running with this call-buying theme, let's see how a KR call trade actually plays out:

Selecting the most recent trade of 250 contracts, which changed hands at 10:47 a.m. Eastern time, the hypothetical trader purchased 250 KR September 30 calls for $0.45, or a total outlay of $11,250 -- ($0.45 * 100)*250 = $11,250. For this trade to reach breakeven, KR would need to rally about 8% to $30.45 per share. We arrive at this by adding the cost of the option ($0.45) from the strike of the purchased 30 call ($0.45 + $30 = $30.45).

Clearly, the central driver behind this trade is KR's earnings report on Tuesday next week. The problem is that the shares need to rally sharply in a short time frame in order for the trader to realize a profit on the position. Luckily, KR has a history of sharp rallies following the company's earnings reports, and an 8% move is well within the 12% rally the shares experienced following Kroger's first-quarter report. Let's see if the stock's sentiment or technical backdrops provide any clues to the possibility that this purchased call position will be profitable before expiration on September 19.

Getting Technical

Technically speaking, KR's outlook is a mixed bag. The shares' rally from their March lows was halted by overhead resistance in the 31 region in mid-August. The stock was sent packing, but found support in the 26 region, and has since bounced back more than 7% to contend with its 10-week and 20-week moving averages. The former trendline poses a short-term hurdle for KR, which could impact any reaction to the company's earnings report. Furthermore, long-term support/resistance looms overhead at the 28.50 level. While the stock has momentum on its side following its recent rebound from support in the 26 region, the 10-week moving average and the 28.50 level could mute any upside potential.

The Sentiment Drivers

The sentiment backdrop for KR is much more supportive of a September 30 call position, as pessimism is running high on the shares, indicating that investors have low expectations for the company's earnings report. Specifically, the stock's Schaeffer's put/call open interest ratio (SOIR) of 1.54 indicates that puts easily outnumber calls among near-term options. This ratio also ranks above 89% of all those taken during the past year, meaning that options traders have been more pessimistic only 11% of the time in the prior 52 weeks. Traders should keep a close eye on this reading heading into next week's event, as an uptrend in the SOIR could indicate that expectations for a positive reaction to earnings are rising.

The other indicator to keep a close eye on is the analysts rankings. According to Zacks.com, 5 of the 9 analysts following KR rate the shares a "hold" or worse. This configuration leaves plenty of room for upgrades following a positively received earnings report. Obviously, if KR receives any positive brokerage comments on its second-quarter earnings report, it could be quite a boost to a purchased KR September 30 call.

The Verdict?

Trading options ahead of events like earnings has never quite been my cup of tea. I always seem to play the wrong side of the trade, or I play an option too deep out of the money only to see the shares fall just shy of breakeven. So, you can take my positive assessment of today's September 30 call with a grain of salt. KR's strong historical fundamental performance, the wealth of negative sentiment, and the stock's reactions to prior earnings reports are all positives for this hypothetical trade. Meanwhile, the detractors on the technical front are muted by the volatility that KR usually experiences surrounding such an event.

If I were to offer one potentially nasty caveat to this trade, it would be the potential for implied volatility to implode following KR's second-quarter earnings report. Currently, the implieds (IV) on the September 30 call rest at 50%, compared to the stock's 1-month historical volatility reading of about 32%. While it is normal for a company's options to experience a rise in IV prior to earnings, we are also seeing volatility from expiration week also being factored in. What this means is that the option is relatively expensive, and traders should be aware of this potential risk.

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Copyright Schaeffer's Investment Research. www.schaeffersresearch.com.