Options Update: Schering-Plough Sees Heavy Option Activity After Delaying Earnings

• July 21, 2008
• Mark Fightmaster

Fair Scher of Negative Action

Earlier this morning, Merck
and Schering-Plough
announced that their second-quarter earnings reports would be delayed thanks to the later release of a study of Vytorin. The pharmaceutical has seen its sales suffer thanks to a “controversial study” showing it was no more effective in treating heart disease than generic versions of Zocor. Thanks to the delayed earnings report, SGP has dropped nearly 10% while MRK has shed slightly more than 2% – which hardly seems fair. This drop has prompted a raft of option activity, both put- and call-related, which is what caught my eye today.

Before delving any further into the option activity, let’s see what SGP’s historical earnings performance holds. With the exception of the most recent third-quarter results, SGP has topped or matched the consensus estimate on a rather consistent basis. In fact, the first quarter of 2008 saw SGP top expectations by a rather sizeable 16 cents per share. We will find out this afternoon if this performance keeps up. For reference, the consensus estimate for SGP stands at 42 cents per share. Now, back to the options …

Today’s Intraday Volume Explosion List makes me think that we could be looking at a strangle strategy, but let’s dig into the numbers before making this assertion. On the put side of the options equation, total daily activity has increased nearly 17.5 times, with 55,361 contracts trading thus far. The largest portion of this activity is centered on the August 17.50 put (SGP TW), with volume of 25,151. Turning to calls, total daily activity has increased nearly 15 times. The vast majority of this activity checks in on the August 22.50 call (SGP HX). The fact that these strikes are out of the money makes me feel good about my assertion that we could be looking at strangles – but let’s not pat ourselves on the back yet.

So much of the activity on the put was marked “late” that I wondered what was up, then I remembered that we were dealing with the delay of the report and the subsequent action. Seemingly every notable transaction had a corresponding transaction marked late. The story was similar over on the call side of the spectrum – which was disappointing. Unfortunately, we have to work on a hypothesis here, but I am fairly confident in my assertion.

Sentiment is Hardly a Scher Indicator

Sentiment is pretty evenly split when it comes to SGP. The pharmaceutical firm sees a bit more optimism from analysts that it does from option players. According to Zacks, SGP receives 6 “strong buys,” 1 “buy,” and 5 “holds.” This configuration hints that the shares are a tad more susceptible to downgrades in the wake of disappointing earnings. Of course, there is a chance for upgrades from the 5 fence sitters, so the stock could garner a bit of momentum from stronger-than-expected results.

Option players are rather non-committal toward SGP, as the firm’s Schaeffer’s put/call open interest ratio (SOIR) of 0.74 ranks in the 51st percentile. While this indicator can hardly be described as residing at an extreme reading, it does hint that the equity could be pushed higher or lower depending on the Street’s reaction to the delayed earnings report.

One final sentiment aspect to deal with ahead of earnings is short interest. Roughly 19.5 million SGP shares are sold short, which computes to 1.2% of the equity’s available float. Should these bears need to buy back their short positions following the earnings report, the upside momentum leant to the shares would be negligible.

How Are the Schers Doing?

Bottom line: the stock is struggling. SGP enjoyed a brief period of prosperity in late 2006/early 2007, but it has been downhill since. Yes, the shares have advanced 15% in the past 4 weeks, but that does not eliminate the fact that SGP has lost 32% in the past 52 weeks and 19.5% since January 1. The growing buying pressure from the past 4 weeks could indicate that optimism is building ahead of this afternoon’s earnings report. However, what does today’s drop in price indicate?

The lines on the chart show that the stock has spent the better part of the past 5 years locked in a trading range. However, it also represents (roughly) the 22.50 and the 17.50 levels, which are the call and put strikes that saw the most action today, respectively. Remember, the hypothetical strangle player just wants a sizeable move in either direction. However, the 22.50 level could be hard to top, especially with the 10-month moving average in the region. On the other hand, the 17.50 level may not be so easily broken – the 18 level has acted as support on many tests in the past.

The Verdict? A very interesting situation is shaping up with SGP. Expectations are mildly bullish, but could unwind in either direction in the wake of a strong or weak report. Moreover, the heaviest of activity has taken place at out-of-the money strikes that have significant hurdles lying between them and the stock price. The one thing that a strangle player does not want to see is a stock that doesn’t move – which is a distinct possibility with SGP.

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