Education Newsletter

What's the Trade?   November 16, 2011

Webinars This Week
DateWebinar TopicPresenterLevel 
November 17
4:00 pm CT
TM104: A Basic Intro to the Spectral Analysis ToolTravis McGhee
November 18
1:00 pm CT
Simple Income Trades with Dan SheridanDan Sheridan
Sheridan Mentoring

November 21
4:00 pm CT

TM105: A Basic Intro to strategySEEK

Travis McGhee


November 22
6:00 pm CT

Calendar Spreads for the Option Trader

Gareth Ryan
IUR Capital


This Week's Education Tip

Option Greeks: Option prices can change due to directional price shifts in the underlying asset, changes in the implied volatility, time decay, and even changes in interest rates. Understanding and quantifying an option's sensitivity to these various factors is not only helpful -- it can be the difference between boom and bust. The option greeks come from the pricing model (normally the Black-Scholes model) that gives us implied volatility and quantifies these factors. Delta, theta, and vega are the greeks that most option buyers are most concerned with. Learn more in our free Education section.
Hot new options for sale--limited-time offer!

As the hype continues over Groupon, interest has shifted to opportunities in the options launched on Monday. But because the discount-of-the-day stock has been around for only nine sessions,we don't even have enough data to look at historical volatility.

The first three trading days since its initial public offering on Nov. 4 were quite volatile, as predicted. Since then, shares have stayed in a tight closing range between $24.04 to $24.41 for the last six sessions.

But the implied volatility of GRPN options remains very high at 97 percent for the front-month at-the money puts and 57 percent for the calls. December puts are at 104 percent, with the calls at 51 percent. April sees an even greater differential.

This usually isn't the case, as options at the same strike typically have the same implied volatility. But hard-to-borrow situations--such as trading after a high-profile IPO with a small float--can create the scenario we see now in Groupon.

Under normal circumstances a trader would sell those puts, buy the calls, and then sell the stock to lock in a profit. But one can't do that in GRPN now.

So are there are ways to take advantage of this situation? First, you obviously must have an idea on what you think might happen to the stock price. If you are bullish, you have the easiest situation: You can buy calls and sell puts in a so-called risk-reversal trade.

For instance, you could sell the January 22 puts for $3 and buy the January 25 calls for $1.60. That creates at credit of $1.40, which you could keep if shares remain between the two strike prices, and a position with tremendous upside potential that won't lose unless shares are below $20.60 at expiration.

Bearish traders, on the other hand, would face a bit more difficulty considering the premiums of the puts. But put spreads do make sense here, and a December 23/19 put spread would cost you just $1.50 to open.

One could also use a bearish put butterfly as the December 15/19/23 spread trades for just $0.95. That offers a risk/reward of more than 3 to 1.

Short calendar spreads on the puts are also interesting but not practical for most traders. They have the margin requirements of a short put position, so the potential gains are often not worth the effort, and you would be making a bet on significant volatility.

Long calendars on the calls might be worth considering. These can be done at the money if you think that Groupon's shares probably won't do much, and the $0.50 cost can potentially get you twice that in profits if GPRN is around the strike at expiration. Directional calendars--in or out of the money--move that closer to a 3-to-1 potential payout.

Regardless of how you want play this name--and even if you don't--it helps greatly to understand the implied volatility of the different options. It tells us something about the stock, what people think about it, and possible ways to play our views on this company and others in the space.
There are always values in the stock market. One place to find them is among sectors and companies that have been distressed and hated for a long time--especially those with lots of debt. They tend to be underowned and heavily shorted, which can provide some nice fuel for a rally.

Many of the gains we enjoyed coming off the lows in 2009 resulted from these kinds of melt-up trades, especially financials and auto-part makers. Plenty of other companies, however, enjoyed only a fleeting bounce and continued to struggle. Some of these now look interesting.

The first are ocean shipping companies. Many of these stocks, such as Frontline, Overseas Shipholding, and Eagle Bulk Shipping, are now trading far below their 2009 lows. This is not a surprise because shipping rates remain far below their peaks in early 2008. And, after an initial bounce in 2009, they trended lower for more than a year.

Now the situation is quietly turning positive. The Baltic Dry Index, a key metric of shipping rates, has been trending higher all year and made higher lows at the same time that the S&P 500 dropped in early October. Reports this month also suggest that demand is improving and a glut of ships is easing.

This improvement is visible on our new researchLAB service, which makes it easy to follow dozens of industry groups. Headlines in the last week have an average bullish-to-bearish score of +1, meaning that they're all positive.

This stands in contrast to a +0.5 rating in the previous month, indicating that sentiment is getting better. Stock performance matches this improvement because shippers are up 14 percent in the last month versus a gain of just 4 percent for the S&P 500.

Another consideration is that the some of these companies are now at truly distressed levels, thanks to their messy balance sheets: EGLE and OSG are trading for less than 0.3 times book value while FRO is at 0.65 times. DryShips is at 0.36 times book value.

While investors have a reason to fear companies with too much debt, they can still rally hard simply by failing to go bankrupt.

Homebuilders seem to be turning as well. Several companies in this industry, such as Beazer Homes, D.R. Horton, and Toll Brothers, cited better orders this earnings season. Margins have also been improving for others, including PulteGroup.

In a related story, famed investor Kyle Bass recently bought a stake in mortgage-guarantor MGIC Investments. Bass made a fortune betting against mortgages back in 2008, so it's noteworthy that he's now taking the other side of the trade.

The final idea is a single company, Rite-Aid, which has been a punching bag for better-run competitors such as CVS Caremark and Walgreen for years. But headlines have been showing more optimism in the last few months, as new customer-loyalty programs result in better same-store sales and earnings estimates inch higher. RAD also trades at less than 0.05 times sales, about one-tenth the multiple for its rivals.

Let me end with a reminder that these are ideas, not recommendations. Back-from-the-dead companies can significantly outperform the market when they turn. However, because they're beholden to forces in the credit market, it's a good idea to learn more about their obligations.

When are their next big bond maturities, and do they have any covenants (strings attached to loans) that might hurt equity investors? Do they have pension obligations?

Some work does need to be done, but it can be well worth the effort.