Rally pumps up the volume in options
06/05/18

It’s not often you see a roughly $100 stock lose around 80% of its value in less than a year—mostly during a roaring bull market, no less—and then rally more than 100% over the next two months.

But such is the story of fiber-optic networking company Applied Optoelectronics (AAOI).

Just two months ago (April 4) AAOI shares hit $22.54, which the weekly inset in the following chart shows was the low point of the stock’s eight-month slide from a high above $100:

Applied Optoelectronics (AAOI), 8/17/17 – 6/4/18. Applied Optoelectronics (AAOI) price chart.

Source: OptionsHouse

Then the stock more than doubled by hitting yesterday’s high of $49.75, jumping 45% in just the past five days, including yesterday’s 10% intraday gain. Yesterday’s up move ended, somewhat conspicuously, right around the bottom of the big down gap from last October.

The stock’s red-hot move over the past week has jacked AAOI options volatility to exceptionally high levels, as the following LiveAction scan shows: Yesterday morning, implied volatility (IV) in AAOI options was up 39.95% from the previous five days.

LiveAction scan: Big 1-week gain in IV. AAOI options implied volatility.

Source: OptionsHouse

Because high IV—which is the market’s expectation of future volatility that is built in to an option’s price—increases option value, it makes sense that AAOI options, all else being equal, may be trading a bit on the rich side. That could be especially true for call options, since the stock’s price move was up: Rising stock prices can mean more demand, and higher prices, for calls.

Well, when something’s potentially overpriced, traders can look at shorting opportunities. For example, in this type of situation some traders may consider a stock’s rapid rise a reason to look for at least a short-term pullback, even if the stock has a longer-term bullish outlook. Then there’s the fact that in this case the stock retreated intraday right as it reached the October price gap. And all this price action is occurring while call options are relatively pricey.

The following chart shows the profit-loss profile for selling 10 $55 AAOI call options (expiring on June 29) for 1.15 ($1,150 total); a different strike price (e.g., $60) could be used, based on what a given trader expected in the way of future price action. As long as the stock price remains below the strike price (other than a small or temporary move above it), the options will expire worthless and the traders gets to keep the collected premium.

Applied Optoelectronics (AAOI) short call option profit-loss profile

Source: OptionsHouse

Although “uncovered” short options trades like this have theoretically unlimited risk (since a call option short seller could be assigned the underlying stock at below-market prices), this type of position also has a couple of potential advantages. First, an option’s “time decay”—the rate at which it loses value over time—accelerates as expiration approaches, especially in the final two or three weeks. Because that’s this position’s time horizon, option sellers would be getting the most out of this effect.

Second, unlike bearish traders who may short the stock and place a stop order above the market to protect themselves, selling call options removes the risk of getting stopped out of a position on minor or intraday moves above the option strike price. For instance, a stock trader who shorted the stock at $49.25 and placed a buy-stop at $55 would get knocked of the trade if the stock spiked intraday to $55.30 (and then, say, fell back to $53), while the seller of $55 call options is unlikely to be assigned stock at $55 on such a move.

Market Movers Update. After making an all-time high last Wednesday, the Russell 2000 index (RUT) started off this week with another one, hitting a record high (1655.71) and close yesterday. The Nasdaq 100 (NDX) ended the day with a new record close, but didn’t quite make an all-time intraday high.

US Steel (X) fell more than 1% yesterday and remained below its spike high from last Thursday, when new steel tariffs were enacted.

 

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