Size Up Stocks Using Option Premiums

Looking for a way to gauge the risk in a stock. The following article explains how to use the option premiums being charged for the stock to determine just how risky the stock is. A very interesting and somewhat logical way to estimate it.

As someone who actively traded the markets during the 2008/2009 financial crisis, I have many memories from that time period that I doubt I’ll ever forget. One observation I made then has to do with the put premiums on the SPDR S&P 500 (SPY) and PowerShares QQQ Trust (QQQ) in late September 2008, just prior to the bottom falling out of the markets. At the time, the VIX was quite elevated but nowhere near the incredible heights it would soon reach, yet puts on the SPY and QQQ were already trading at “you’ve got to be kidding me” prices. At the time, it seemed to me as if the market makers were almost daring people to sell the puts. Way out-of-the-money puts expiring just a few weeks later in October were trading at premiums normally reserved for options expiring many months later. On the flip side, it seemed crazy to purchase the puts betting on further declines in the major market indices at the prices they were being offered for. Yet, that was exactly what an investor wanting to make money should have done.

I’ve seen this sort of thing on the option chains of individual stocks many times since those captivating days of late 2008. On many occasions, I end up quite impressed with the forecasting abilities of options. It makes sense that market makers will do what they can to mitigate risk when they perceive unusual risks in securities and/or markets. If maintaining a delta-neutral portfolio requires pumping up not just put option premiums, but call option premiums as well, so be it. The good news is that this provides valuable information to the investor interested in the underlying stock. Of course, this is not an infallible strategy for predicting what the future will be for a stock’s price. However, in my experience, I’ve found options to be a worthwhile tool for helping to gauge risk levels in a stock, as well as in helping to determine when difficult times for a security may be coming to an end.

Observing and contemplating the meaning of option premiums is also useful as part of a wider set of research when determining at what price to purchase a stock. Beyond using chart analysis, options can help investors determine at which levels a stock might experience support or resistance. Option premiums can also help investors become aware of potential upcoming big moves in a stock and the time frames for those moves. In general, options can help investors gauge the mood of the market, and therefore are worth exploring in your research.

With all this in mind, I’d like to offer a few examples of relatively large put premiums that currently exist on various stocks.

For Bank of America (BAC) shareholders, the risks just don’t seem to want to go away, and the options show it. The January 18, 2013 $5 puts are currently bidding at 65 cents. This means that the market is willing to pay an investor 13% to purchase BAC at a price 25.37% lower than its current price of $6.70. In fact, by selling those puts, Bank of America would have to decline 35.07% over the next twelve months before the put seller even begins to lose a penny.

Does this seem like the type of return you can get across the board in today’s zero-interest-rate policy world? Despite the fact that BAC has rallied over 36% in about a month, the market is still offering large premiums to the put seller. On the other hand, when looking at the call premiums, the market is offering a call buyer the opportunity to purchase BAC at $7.50 (just 11.94% out-of-the-money) for a premium of 14.13%. This premium is almost identical to the $5 put premium, but not nearly as far out-of-the-money.

What does this tell you? It doesn’t necessarily mean the call options are cheap. Instead, it tells me there are still very real risks to this stock over the next twelve months.

Are you a Diamond Foods (DMND) shareholder comforted by the Keybanc Capital Markets analyst who on December 9, 2011 stated that the internal audit the company is conducting will turn out okay and that DMND’s acquisition of Pringles is likely to go through? The options market isn’t quite as sanguine. Currently, the January 18, 2013 options allow the put seller to go roughly 27% out-of-the-money to the $23 strike price and still collect a premium of 17.83%. Amazingly, the March 16, 2012 options, expiring just two months from now, offer an opportunity for an options trader to sell the $17.50 puts, almost 45% out-of-the-money and still collect a premium of 3.71%.

On the call option side of the equation, the March 16, 2012 options also require the call buyer to go roughly 43% out of the money to get an offer with a 3.89% premium. When looking out a year from now to the January 18, 2013 calls and going 27% out-of-the-money, the $40 strike price is offered at $6.00, a cost of 15% for the call buyer.

At the risk of stating the obvious, the options market believes that despite the upbeat analyst comments from December, things are completely up in the air regarding the stock price of Diamond Foods. The market seems utterly confused about where the stock might be over the course of the next year, and is pricing in the potential for big moves in either direction.

Computer Sciences (CSC)– recently put on review for a possible credit downgrade by Moody’s as well as being downgraded one notch by S&P– is a company with an option chain full of inflated premiums. With the stock trading at $25.50, the January 18, 2013 $20 puts, more than 21% out-of-the-money, are bidding $2.70 (with a wide bid/ask spread). The $2.70 bid means the put seller is being offered an opportunity to collect 13.50% and only forced to buy the stock after it declines more than 21% from current levels. In fact, losses only begin to accumulate after a decline of 32.16% from current levels.

Are you willing to take that risk? Or, are you wondering if perhaps all the company-specific concerns the market has already heard of late are just the beginning? Do you view the option premiums as a warning to stay away or as an opportunity?

Sears Holdings (SHLD), a company whose debt was recently downgraded to C-rated paper and that recently announced store closings and a couple billion dollars in charges, has an option chain tempting the put seller with massive premiums. The stock recently traded at $38.14, and the January 18, 2013 $15 put option– more than 60% out-of-the-money– is bidding $3.85 (with a wide bid/ask spread). The market is offering a 25.67% return over the next year if someone is willing to purchase Sears at a level more than 60% below where it currently trades. Furthermore, losses won’t even begin to accumulate until the stock drops below $11.15, 70.77% lower than where it stood at the time this article was written. On the call option side of the equation, SHLD January 18, 2013 $60 calls that are roughly 60% out-of-the-money are only asking $2.67, a tiny 4.45% premium.

Are the calls cheap? Is the market crazy for offering the premium it is offering on the puts? Are the puts just free money waiting to be snatched up? Or, are the options telling us that only investors with the highest level of risk tolerance (and maybe not even those investors) should be considering SHLD at current levels. It appears as though the market believes SHLD could be heading for a very large fall from current levels over the next twelve months. If you disagree, you have an opportunity to make quite a nice return on your investment by selling SHLD puts.

Options prices are certainly not a crystal ball, and analyzing option premiums without regard for implied volatilities and the liquidity of the various strike prices in question would be an incomplete exercise. However, as I mentioned previously, options prices are a useful tool for helping an investor to gauge the mood of the market. Among other things, they also help to determine the greatest risks, in terms of magnitude and direction, for the underlying stock’s price. On a closing note, the stories that options premiums tell on a regular basis are something that investors who learn to read those stories might find constructive when trying to decide entry and exit points on individual stock holdings. Over time, this can help provide a nice boost to your portfolio’s bottom line.

See Seeking Alpha for the rest of the story

Option Trading Secrets

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