Options Corner: A Contrarian Case Builds As Traders Short Chewy Ahead Of Earnings

As a rule of thumb, investors generally want to see positive sentiment in the options market prior to a company's earnings disclosure, which explains why some traders may be hesitant on Chewy Inc CHWY. An online retailer of pet food and products, Chewy has attracted unwanted attention ahead of its June 11 earnings disclosure. At the same time, the contrast between pessimistic options trades and relatively strong fundamentals sets up an intriguing contrarian play.

Just recently, CHWY pinged Benzinga's screener for unusual options activity thanks to a sweep transaction involving sold calls; specifically, 1,400 contracts sold of the $42.50 call expiring July 18 of this year. A credit-based transaction, this trade assumes that by the expiration date, CHWY stock will not be trading higher than the strike price plus the premium received as income.

Further, this trade also assumes that CHWY will not materially rise higher prior to expiration. If it does, the other side (i.e. the call buyer) owns the right to exercise the option early. Thus, the call writer (seller) would fall under assignment.

It may seem like a bold bet but it also aligns with brewing skepticism against CHWY stock. Last month, CHWY's short interest was only 3.7% of its float, while its short interest ratio was only 1.75 days to cover. Currently, the security's short interest stands at 10.3% of its float, while its short interest ratio increased to 3.16 days to cover.

However, the bears are taking a huge risk. According to the APPA National Pet Owners Survey, 66% of U.S. households own a pet. Further, millennials and Generation X represent the largest demographic groups among pet owners, indicating a growth trajectory based on their relative youth.

As such, CHYW stock presents a compelling sentiment war.

Market Breadth Data May Give CHWY Stock The Upper Hand

While there are many ways that options traders approach opportunities in the derivatives market, primarily, sector participants recognize the importance of probabilities. With standard investing, the focus is on the "why" of the target opportunity. With options, the focus is on the "how" — how much, how fast and most importantly, how likely.

As a baseline, CHWY stock is a difficult nut to crack because it technically features a negative bias. On any given week, the chance that a long position will be profitable is only 49.35%. Functionally, this figure is calculated by a simple rise-over-run-style equation: take the number of positive weeks divided by the total number of weeks in the dataset.

Still, it would be unfair to label CHWY stock as being a poor trade under all sentiment regimes. In other words, certain sentiment cycles may generate long-side probabilities that differ significantly from the baseline.

From a market breadth perspective, in the past two months, CHWY stock has printed an "8-2-U" sequence: eight up weeks, two down weeks, with a net positive trajectory across the 10-week period. Notably, in 57.14% of cases, the following week's price action results in upside, with a median return of 7.3%.

Should the implications of the 8-2-U sequence pan out as projected, CHWY stock could theoretically hit $47.13 (based on last Friday's close of $43.92), perhaps within a week or two. Adding to the fire, speculation ahead of the earnings report could create a buy-the-rumor, sell-the-news effect. As such, the high short interest for the bears could devolve into a short squeeze.

Plus, market breadth data is essentially signaling that CHWY stock is no longer a statistical coin toss. Rather, it's closer to a 60/40 wager, thus favoring a debit-based options strategy.

An Aggressive Wager For The Contrarian

Those who want to bet against the bears and take a long-side wager on CHWY stock may consider the 45/46 bull call spread expiring June 6. This transaction involves buying the $45 call and simultaneously selling the $46 call, for a net debit paid of $47. Should CHWY rise through the short strike price at expiration, the maximum reward is $53, a payout of almost 113%.

Mainly, this trading idea is attractive because of the aforementioned market breadth sequence. Ordinarily, CHWY stock is slightly worse than a 50/50 wager. But with the response to the 8-2-U sequence, the odds shift in favor of the bulls. Throw in the possibility of a short squeeze and CHWY may have enough fuel to trigger the $46 target at expiration.

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