Options Update: VMware Call Volume Soars

VMware Inc.
(
VMW |
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is once again the target of heavy call volume in the options pits today, despite the general lack of any news driving the activity. More than 10,500 VMW calls have traded so far, more than tripling the stock’s average daily call volume. While this activity was enough to pique my interest on the equity, it was the 6,800 call contracts crossing the tape on VMW’s soon-to-expire September 35 strike that caught my eye today. With open interest totaling just 4,603 contracts, it is possible that we are looking at the initiation of new positions on an option that is set to expire in about 7 trading days.

VMware volume details

Looking at the chart above, you can see that the vast majority of today’s volume changed hands at the ask price, suggesting that traders are buying (to open) VMW calls. For today’s call-buying example, I’ll be using the combined block of 710 contracts that traded at 10:58 a.m. Eastern time. However, there was a pair of blocks that traded at the bid at 10:56 a.m. Eastern time – suggesting the contracts were sold (to open). The combined block of 1,000 contracts that traded at 10:56 a.m. will represent out call-selling example today.

Anatomy of a VMware Call Position

Starting with today’s call-buying example, the hypothetical trader purchased 710 VMW September 35 calls for $1.30, or a total outlay of $92,300 — ($1.30 * 100)*710 = $92,300. For this trade to reach breakeven, VMW would need to rally about 8% to $36.30 per share. We arrive at this by adding the cost of the option ($1.30) to the strike of the purchased 35 call ($1.30 + $35 = $36.30). The total loss for this position is limited to the initial investment of $92,300.

Meanwhile, the call-selling trader sold 1,000 VMW September 35 calls for $1.20 or a total credit of $120,000 — ($1.20 * 100)*1,000 = $120,000. Remember, in a call sell position, all a trader needs is for the underlying stock to remain below the sold strike through expiration. So, as long as VMW stays below 35 through September 19, the call-seller keeps the premium received. The total loss for this position varies on your strategy. If the call is not covered (i.e. you don’t own the shares), then your losses are potentially unlimited, as the stock could theoretically rally infinitely. If you own VMW shares, then you keep the premium and receive $35 per share when the stock is called away from you at expiration. The only potential loss is viewed as opportunity cost, where the stock rallies significantly above the sold call strike.

So, assuming you don’t want to have your VMW shares called away from you, does the call-selling position or the call-buying position hold more potential for profit? Let’s see if the stock’s sentiment or technical backdrops provides any clues.

Getting Technical

Let’s face the facts here: since November 2007, VMW has been a dog of a stock. During this time frame, the security has plunged more than 73% and is now trading well below its initial-public offering in mid-August 2007. The shares continue to be driven lower by resistance at their 10-week and 20-week moving averages, with the former trendline quickly descending into the 35 region – home to the purchased call. The stock’s historical price action supports the sold September 35 call, diminishing the chances of VMW rallying above the strike before expiration.

There is some support for the purchased call, however, as VMW seems to have found a bottom in the 32 area. This region has buoyed the equity since July 23. Furthermore, if the shares can find the buying strength to move solidly above the 35 level, the next potential technical hurdle rests at the 40 level. However, such a move would represent a mere 10% gain for the purchased September 35 call – a meager return at best.

Weekly chart of VMware since August 2007 with 10-week and 20-week moving averages

The Sentiment Drivers

The sentiment backdrop for VMW offers little in the way of potential fuel for a rally. Short interest accounts for 21% of the stock’s total float, but investors are still adding to their positions as short interest jumped more than 4% during the most recent reporting period. Additionally, these bearish investors will not be in any hurry to abandon their winning positions on a stock that has dropped more than 60% so far this year.

Meanwhile, 15 of the 19 analysts following VMW rate the shares a “hold” or worse, according to Zacks.com. But these brokerage firms are in a bind similar to the short-selling community, as upgrades on a falling stock are much less likely. Additionally, Thomson Financial reports that the average 12-month price target for VMW rests at $36.70 per share, placing a potential cap on the security’s upside unless analysts boost their price targets.

SOIR chart for VMware

As for options traders, calls remain the investment vehicle of choice for this speculative group. VMW’s Schaeffer’s put/call open interest ratio (SOIR) of 0.73 ranks in the 36th percentile of its annual range, and has fallen steadily. In fact, the stock’s SOIR has dropped precipitously from its near-term peak of 1.02 in the 77th percentile on August 29. However, this rising optimistic sentiment from options speculators has bearish implications from a contrarian standpoint, given VMW’s poor technical performance.

Sentiment indicators for VMware

The Verdict?

While there is the potential for a rally in the shares, given the technical support, high short interest, and negative analyst ratings, overhead technical resistance looks quite daunting. Even if VMW manages to surpass near-term resistance at the 35 level, the 40 region is poised to limit any rallies in the shares – capping potential returns on the September 35 call at roughly 10%. Meanwhile, a sold September 35 call looks quite inviting given the technical hurdles in place for VMW, and as a covered call (i.e. owning the shares) the position could be a nice way to offset some of the stock’s poor price action.

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