One options trader predicted Macy's earnings meltdown

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Options traders bet retail rally will be cut short when Macy's reports

A newly inverted yield curve isn't the only factor driving retail lower Wednesday after its best day in more than two months.

Macy's is on pace for its worst day in more than two years after delivering a lackluster earnings report before the bell.

It was a move that few saw coming. The stock's average post-earnings move is about 7.5% in either direction into the close of the week, and the options market was only predicting a slightly larger move of 9% this time around.

On Tuesday's edition of "Fast Money, " "Options Action " trader Michael Khouw, president of Optimize Advisors, offered some insight as to why that prediction turned out to be wrong.

"[That] might seem like it's bigger than average," said Khouw, "but it's worth considering that this stock has fallen sharply, and as it has done so, the equity is going to become more volatile because the rest of the balance sheet hasn't been shrinking. You've basically got a lot of debt, here."

As Khouw would point out, there was one trader who recognized that potential for increased volatility and bet on an 18% drop in the stock over the next month.

This trader bought 2,350 contracts of the September 27 weekly expiration 18.5/16-strike put spreads for 70 cents in premium. That trade would break even about 8% down from where the stock was trading Tuesday, and the lower strike of the put spread would represent an 18% drop from Tuesday's close.

While it looks like this trader pegged the move in the stock perfectly, the stakes were higher than usual, given elevated options premiums heading into a major catalyst like earnings. That's doubly true, since the options market was pricing in an above-average implied move.

"When you have stocks like this, that have declined considerably, you're actually adding leverage to the equity, and you have to price that into the options," Khouw said. "Given that fact, I think options are still cheap going into earnings right now."

Macy's was trading more than 15% lower in Wednesday's session.

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