Options Update: Strangling VMware Inc.
Since the company’s lackluster earnings report on July 22, VMware
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PowerRating) has offered up less-than-compelling price action. While VMW’s second-quarter report was inline, investors balked when the firm placed third-quarter sales estimates between $462 million and $468 million, versus Wall Street’s expectations for revenue of almost $497 million. Since July 22, the equity has drifted between support at the 33 level and resistance at the 37 level. That changed today, however, as VMW has surged nearly 10% higher on no discernable news.
Naturally, this sharp rally in the shares has piqued the interest of options speculators, placing VMW on today’s Intraday Volume Explosion List. More than 14,300 calls have traded so far today, more than quintupling the equity’s average daily call volume. Meanwhile, roughly 7,600 puts have changed hands, easily quadrupling VMW’s average daily put volume. While this activity was notable enough, it was the focused attention to the September 45 call and September 35 put that caught my eye today.
Straggling VMware
Digging into the activity, I discovered that a block of 6,000 VMW September 45 calls (VMW II) traded at 11:38 a.m. Eastern – crossing at the price of $1.63. At the same time, a block of 6,000 VMW September 35 puts (MKT UG) changed hands at the price of $1.33. Given that the trades when off at the same time and are of the same size, we are most likely looking at a September strangle for VMW. For reference, a strangle is the simultaneous purchase or sale of an equal number of puts and calls on a given underlying stock with the same expiration date but different strike prices.
The trade works like this: our hypothetical trader buys 6,000 VMW II contracts for $163 each ($1.63 * 100), for a total outlay of $978,000. Simultaneously, the trader buys 6,000 MKT UG contracts for $133 each ($1.33 * 100), for a total outlay of $798,000. The total cost of the position amounts to roughly $1.78 million. The idea behind this strategy is for VMW to move sharply (the direction doesn’t matter) before the options expire on September 19.
For the trade reach break-even, VMW must rally about 16.6% to about $48 per share, or fall 24.8% to about $32 per share. To arrive at our breakeven target, we add the cost of both options and add/subtract that total to the purchased strikes. For instance, on the call side, we add $1.63 (the price of the call) to $1.33 (the price of the put) to arrive at 2.96. By adding this figure to 45 (the purchased call strike), we see that VMW needs to rally to roughly $48 per share in order for the trade to reach breakeven. On the put side, we’d subtract 2.96 from 35 (the purchased put strike) to arrive at a breakeven of roughly $32 per share.
Technically Speaking
The question now becomes whether or not VMW can post such a volatile move in the next month. The stock’s stagnant performance during the past 2 months certainly doesn’t support such a sharp move, but a closer look may reveal the potential for just such an occurrence over the next couple weeks. Today’s rally in the shares has placed them squarely in contention with round-number resistance at the 40 level. This level has offered up both support and resistance during the past several months, and could provide a line of demarcation for buying and selling in the shares. Specifically, when VMW pulled back to near the 40 level in March, the shares rebounded for a rally of more than 42% to its peak in mid-May. On the other hand, when the shares breached this region in early July, VMW fell more than 30% to its late-July lows.
The Sentiment Drivers
So, we know that VMW can achieve the necessary moves of 16.6% and 24.8% to place our hypothetical strangle in the money, but what about a driver for such a surge? This is where investor sentiment enters the picture. Currently, negativity rules the roost for VMW. On the options front, the stock’s Schaeffer’s put/call open interest ratio (SOIR) of 0.96 ranks above 76% of all those taken during the past year, while 22.5% of the equity’s total float is sold short. Finally, 15 of the 20 analysts following VMW rate the shares a “hold” or worse.
On the upside, if VMW extends today’s rally above the 40 level, we could see capitulation from the options crowd and a short-squeeze rally, as investors seek to close out their losing positions in a rush. Along those lines, any upgrades from Wall Street could also increase buying pressure on the shares, potentially pushing VMW closer to the strangle’s break-even of $48 per share.
On the downside, if the shares fail to breakout above resistance at the 40 level, we could see just the opposite occur. If VMW begins to pullback from overhead resistance, it could embolden short sellers and increase selling pressure on the equity. In the event of such a decline, technical support doesn’t being to emerge until the 32-33 region, placing the strangle very close to the breakeven mark on the lower end of the trade.
The Verdict?
Given the volatile nature of the market recently, it’s been very hard to predict any kind of sustainable move. Fortunately for our hypothetical strangle trader, this works to his favor. Personally, given the stock’s exceptionally poor performance this year (VMW is off more than 57% since January) and the strengthening technical resistance at the 40 level, I am betting that VMW will reverse course toward its lows of the past month. However, with a solid looking floor in the 32 region, I’m not sure how much of a profit our straddle player will make from this play.
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