Selling Premium On Cisco And Arista

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The News

On Friday, July 13th, news dropped that Amazon (AMZN) is planning to sell its own networking switches to customers. Switches are part of the enterprise computing market and move data traffic around networks. The Amazon switches would use unbranded hardware and open-source software. They would also include built-in connections to the Amazon Web Services cloud where they could access servers and storage. This would hypothetically take market share away from existing producers of network switches such as Cisco Systems (CSCO), Arista Networks (ANET), and Juniper Networks (JNPR). Reports have stated that Amazon’s switches could launch for sale within the next 18 months at a steep discount to current offerings. Current customers of Amazon will likely be the first target market for the switches when (and if) they are brought to market.

The Reaction

Networking companies CSCO, ANET, and JNPR sold off after the news was released on Friday. CSCO was down 4.13%, ANET was down 4.26%, and JNPR was down 2.28%.

Chart CSCO Price data by YCharts

As can be seen from the chart above, there was a sudden dip in stock price for all three stocks shortly after the news was released, and a small rebound from the lows of the day.

Analysts have already been jumping to the defence of the networking companies, with RBC’s Mitch Steves remaining bullish on CSCO and ANET. Both companies have solid businesses with potential for continued growth. The Amazon bombshell remains unverified and Amazon switches will likely not enter the market any time soon.

Trade Ideas

After looking at the options chains of ANET, CSCO, and JNPR, a trade in ANET looks like the best way to profit from the recent moves in stock price. This is a neutral/bullish trade that assumes the market is overreacting, and that ANET’s stock price will remain stable. With such a sudden move down in the stock price with a rebound already occurring towards the end of the day, further downside seems limited and unlikely in the short term for ANET and CSCO. An advantage of choosing ANET is the higher stock price. You will likely pay less commissions because you can trade less contracts to get a trade of the same size compared with options on a lower priced stock.

When selling premium, I like to look at options with expiration dates 30-45 days out, to give my trade time to be right, while also taking advantage of the rapid time decay in the value of options as they near their expiration. Looking at options on ANET of the expiration Aug. 17, 2018, investors could sell the puts with a 240 strike price and buy puts with a 230 strike price. This trade would be profitable if ANET trades above 240 minus the premium collected for the trade. It is also necessary to consider that ANET has earnings coming up on August 2nd.

For a less capital intensive trade, investors could consider turning this trade into an iron condor by selling a call spread. Investors could sell the 310 calls and buy the 320 calls with the previously discussed put spread to create an iron condor. The short contracts would expire worthless and the trader would collect the full premium of the trade if ANET trades between 240 and 310. As of this writing, this trade has a max profit of $313, and a max loss of $687 for a one contract trade. The call strike of 310 is just slightly lower than ANET’s all-time high of $311.67.

For a slightly more bullish trade, a trader could simply move up the strike price of the put options by $10, selling the 250 puts and buying the 240 puts. This trade assumes that near-term downside to ANET’s stock has been mostly priced in, and that the coming earnings will be neutral to bullish. The trade would now collect $403 in premium, with a max loss of $597. One significant downside of turning this trade into an iron condor is the possibility of a bullish earnings surprise from ANET. Considering this, leaving the trade as a bullish put spread may be safer.

Chart ANET data by YCharts

Similar trades may be made using options on CSCO. One advantage of trading CSCO is that there is a higher volume of options trading on the stock. CSCO also has earnings later in the month, on August 15th. A trader selling premium with an expiration date of August 17th would probably want to close their trades early to avoid the chance of large swings in the price after earnings. One would also need to trade a larger quantity of CSCO options due to the lower stock price of CSCO, which can lead to higher commissions. I favor ANET for the discussed trades because of the higher stock price and the ability to collect more premium on the trades due to the higher implied volatility of the stock (CSCO has an IV rank of 55.2, whereas ANET has an IV rank of 74.8 [source: tastyworks]).

Chart CSCO data by YCharts

For all of these trade ideas, it is often a wise strategy to take profits early if the trade moves in your favor. If you are unsure of when to take profits, a good rule of thumb is to close the trade once you can secure 50% of the premium in profits.

Conclusion

This trade takes advantage of a drastic swing in the prices of stocks as the market reacts to news. I recently completed a similar trade after news of AMZN acquiring the online pharmacy Pillpack was released. Pharmacy stocks, including Walgreens (NASDAQ:WBA), reacted negatively with large moves of over 8% downwards on the day. On 7/02, WBA stock was still down but starting to show signs of recovery, so I decided to sell bull put spreads in WBA. I closed the trade on 7/06 and was able to collect over 50% of the premium (sold for .44 credit, closed for .19 debit). This is an example of how a similar trade can be closed for a profit in a short amount of time as the stock price stabilizes after the volatility shock of negative news. Hopefully, the ANET trade will be a similar story.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANET over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may trade options in the discussed stocks over the next 72 hours.