Options Update: Straddling General Motors Amid Bankruptcy Speculation

It took a full week of price-target cuts, downgrades, and credit-watch negative statements, but options players have finally decided to dive into General Motors
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Today’s bankruptcy speculation arrives on the heels of a slew of negative news for the Detroit automaker. On Tuesday, the Detroit News reported that GM hopes to borrow approximately $500 million from Detroit pension funds to refinance the Renaissance Center. On Wednesday, the stock was downgraded to “sell” from “hold” at Citibank, while GM was placed on credit watch negative” at Standard & Poor’s yesterday.

While GM has vehemently denied the bankruptcy rumors, an article on BusinessWeek reports that the company could announce additional production cuts soon. The barrage has proven too much for options traders to resist, as more than 25,000 puts have changed hands on GM so far today, more than doubling the stock’s average daily put volume and placing the shares on today’s Intraday Volume Explosion List. However, it was a block of 3,000 contracts, which traded at 12:21 p.m. Eastern time and was marked as a “straddle,” that caught my eye today.

General Motors option volume details

Digging into the activity, the block of 3,000 GM October 5 puts crossed at the ask price of $0.81. At the same time, a block of 3,000 GM October 5 calls changed hands at the ask price of $1.09. Given that the trades when off at the same time and are of the same size, we are most likely looking at an October straddle for GM. For reference, a straddle is the simultaneous purchase or sale of an equal number of puts and calls on a given underlying stock with the same expiration date and strike prices.

Anatomy of a General Motors’ Straddle Position

The trade works like this: the trader buys 3,000 GM October 5 puts at $0.81, for a total outlay of $243,000 — ($0.81 * 100)*3,000 = $243,000. Simultaneously, the trader buys 3,000 GM October 5 calls, for a total cost of $327,000 — — ($1.09 * 100)*3,000 = $327,000. The total price tag on the position arrives at $570,000. The idea behind this strategy is for GM to move sharply (the direction doesn’t matter) before the options expire next week on October 17.

For the trade reach breakeven, GM must either rally about 44% to $6.90 per share, or fall 34% to about $3.10 per share. To arrive at our break-even target, we add the cost of both options ($1.09 +$0.81 = $1.90) and add/subtract that total to the purchased strikes. For instance, on the call side, we add $1.90 and add this figure to purchased October 5 call ($5.00 + $1.90 = $6.90). On the put side, we’d subtract $1.90 from purchased October 5 put ($5.00 – $1.90 = $3.10).

Clearly, the trader would need a sizeable move from GM. However, given the recent market volatility, and the fact that the shares plunged 31% yesterday, there is certainly precedent for such surge or decline in the equity. As such, let’s see if the stock’s technical picture or sentiment backdrop provide any clues on the potential for sharp moves out of GM shares.

Getting Technical

A look at GM’s technical performance certainly favors the put side of the straddle. Since January, the stock has plummeted more than 80%, pressured lower by its 10-week and 20-week moving averages. Currently, the security is battling with potential resistance at the 5 level. A rejection here would also benefit the put side of the October 5 straddle position, as we could see GM succumb to additional selling pressure following such a move.

On the other hand, a close above the 5 level could indicate that selling pressure has reached a pinnacle. Should bargain hunters move in to snatch up GM shares, the 5 level could provide technical support for such an influx of buying pressure. Taking this possible scenario in context with the stock’s sentiment backdrop (which we will get to shortly), we finally find merit for the call side of the October 5 GM straddle position.

Weekly chart of General Motors since January 2008 with 10-week and 20-week moving averages

The Sentiment Drivers

Sentiment toward GM is mixed, and offers drivers for both sides of the straddle position. In support of the bearish aspect of the trade, the stock’s Schaeffer’s put/call open interest ratio (SOIR) of 1.07 ranks below 92% of all those taken during the past year. Should these optimistic options traders begin become disillusioned with GM, we could see a spike in selling pressure as this bullish sentiment unwinds.

Meanwhile, Zacks.com reports that 8 of the 9 analysts following GM rate the shares a “hold” or worse. While upgrades amid rumors of a bankruptcy are unlikely, there is the possibility that some brokerage firms could see value in GM given the stock’s heavy losses during the past several sessions. A valuation-based upgrade could be just the driver needed to push the shares sharply higher, benefiting the bullish aspect of the October 5 GM straddle position.

Sentiment indicators for General Motors

The Verdict?

While I would be more inclined to drop the October 5 call and place my bets solely on a GM October 5 put, dropping the call position could be potentially hazardous in the current market environment. Even if the trader’s expectations are for GM to drop sharply, the October 5 call provides a nice hedge in the event of a rebound. With the market enduring 8 consecutive days of heavy selling pressure, it is a good idea to protect against the possibility of an oversold bounce.

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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.