Digging for diamonds
Let’s say a trader was looking for a stock with potential upside, and was possibly considering using options to take advantage of their additional leverage. What characteristics could give them an edge? Here’s one possibility:
●Stock price near recent lows
●High options implied volatility (IV)
●Signs of a stock rebound
There could certainly be other criteria, but let’s consider the information these give us. The first would imply the stock has pulled back and presumably has room to run on the upside—i.e., this is about trying to buy low and sell high, not buy high and sell higher. The second suggests the market expects higher-than-normal volatility soon, while the third means there’s some tangible evidence that the stock could rally.
Yesterday, this checklist may have pushed Signet Jewelers (SIG) onto some traders’ watchlists.
Source: Power E*TRADE
First, Signet (the company behind Kay Jewelers, Jared, and others) appeared at the top of a LiveAction scan for large one-week increases in implied volatility (IV), and the chart above shows SIG options IV was higher than its 30-day average for several expirations.
The daily price chart below shows a couple of interesting things. After rallying off its early-February lows, SIG pulled back Monday-Wednesday (along with the broad market) but, after falling to a lower low yesterday, it rallied to push into positive territory as the US market suffered its worst intraday decline of the week. Signs of bullish resilience?
Given this confluence of factors, some short-term traders may have considered a long stock trade, maybe risking a move a little below yesterday’s low, or (perhaps for a longer-term position) in the vicinity of the February bottom.
On the options side, the fact that IV appeared to be relatively high rather than relatively low may have been an argument in favor of selling options instead of buying them, since high IV often translates into higher options prices. And if a trader expects a stock to rally, this would mean selling puts rather than buying calls.
The chart below shows the risk-reward profile for a short April $22.50 put. While the position’s profit is capped at the amount of premium collected, selling options instead of buying stock gives the trader more leverage—which is a benefit if the trade pans out, but a drawback if it doesn’t—and also allows the trader to capitalize on time decay, which is the loss of value that affects all options over time, and accelerates as expiration approaches.
A final observation: In this case options sellers would have one additional potential risk: SIG’s next earnings release, which is currently scheduled for April 3 (i.e., before the options expire on April 18). Volatility can spike around earnings, which could temporarily pump up options premiums—not what a put seller would want. But that leaves another three weeks for volatility to subside.
There’s often more than one way to approach a trade, but you need to weigh all the risks and potential rewards of each choice.
Market Mover Update: Yesterday’s decline dropped the S&P 500 (SPX) to its early-February swing high—the level noted in “Trade talks put focus on pullback.” Target pulled back yesterday after its big Tuesday-Wednesday rally (see “Retail stock bullseye”).
Today’s numbers: Jobs report (8:30 a.m.), Housing Starts (8:30 a.m.).
Today’s earnings include: Big Lots (BIG), Tenneco (TEN), Vail Resorts (MTN).