Some Intriguing Possibilities

  • July 16, 2001
  • Len Yates

Options
continue to be cheap by recent standards (the past couple of years).
In some stocks, options are the cheapest they’ve been in over five
years. These include America Online
(
AOL |
Quote |
Chart |
News |
PowerRating),
Clear Channel Comm.
(
CCU |
Quote |
Chart |
News |
PowerRating), Cephalon
(
CEPH |
Quote |
Chart |
News |
PowerRating), Genentech
(
DNA |
Quote |
Chart |
News |
PowerRating),
Goldman Sachs
(
GS |
Quote |
Chart |
News |
PowerRating), ImClone Systems
(
IMCL |
Quote |
Chart |
News |
PowerRating), Nvidia
(
NVDA |
Quote |
Chart |
News |
PowerRating), and Dell
Computer
(
DELL |
Quote |
Chart |
News |
PowerRating).

Thus if you have a
bias in any of these stocks (and it looks like some of them are turning down),
the strategy of choice would be a simple option purchase (puts).

The broad market
indexes completed a head-and-shoulders pattern on June 11, and have been in a
downtrend ever since. The rally July 12
and 13 took us back to the top of a channel, potentially setting up a good entry
point for new bearish positions.

America
Online
(
AOL |
Quote |
Chart |
News |
PowerRating)

One stock in
particular, mentioned above as having cheap options, and exhibiting a bearish
chart pattern, is AOL.  Its nearby
options have an IV of 43%, and some of its farther out options have IVs as low
as 38%. Seen in historical context (see
the illustration below), there is significant opportunity for these options to
expand, especially if IV returns to a more normal 60%+ level.



If you agree with my
bearish bias, you could consider buying the October at-the-money puts, with 99
days to expiration, currently priced at 4.40 (IV=41.9%), or go to the farther
out January at-the-money puts, with 190 days to expiration, currently priced at
5.50 (IV=39.1%). Either option would
provide ample time for the stock to move, and both would respond well to a
volatility increase. The farther out
option would move more slowly in response to the stock, but would probably
respond a more vigorously to a volatility increase.

More conservatively,
one could enter into a straddle — buying both puts and calls — with the idea
of playing volatility alone. (Many feel
they don’t have the skills to call the direction of a stock or the market, and
I don’t blame them. It’s a tough
thing to do!  Half the time I think
I can tell what’s coming next, I’m probably just deluding myself.)Dell
Computer
(
DELL |
Quote |
Chart |
News |
PowerRating)

Another interesting
opportunity is Dell Computer. This stock’s
options are cheap, not only historically, but also because they don’t even
reflect the stocks current SV!  See
the chart below, how IV is significantly beneath SV. 
So this stock’s options are cheap, cheap, cheap!



The last time I
alerted readers about cheap Dell’s options was in September 2000. 
In the months following, IV soared to 90%!

Dell’s chart
pattern is bullish to flat. If you’re
bullish on Dell — perhaps expecting good numbers from the company in August
— you could buy calls. (If you’re
looking for “flat” to continue, there is nothing to do. 
A flat forecast + cheap options = nothing to do.)

Looking at the Dell
Matrix today, I was intrigued by the Nov 35 calls because of their IV.
At just 42.4%, they were much lower than most of the options around them,
although not so low that it would make me believe that I had received a bad
price. (For example, the August 40 calls,
with an IV of 71.8%, is most assuredly a bad price.
You probably couldn’t sell these apparently expensive options for 0.05,
let alone 0.20.)

So buying the Nov 35
calls is one possibility. As
out-of-the-monies, I would want to set a time frame of, say, three months for
the trade to go my way and to get out if it doesn’t.

Another intriguing
possibility, more for the gambler, is buying the Jul 30 calls for 0.20 each.
These expire in eight days. The
market is saying, by the way it is pricing these options so cheaply, that Dell
will not go above 30 in the next eight days. Hmm.
That’s only 1.69 points away. If
the stock can go just 1 point higher than that — to 31 — I’ll 5x my money.

Watch
For Rally

Despite bearish
comments above, we need to be watchful. The
market could reverse and go into a rally at any time; a rally lasting perhaps
several weeks, if not more. Mutual funds
have a lot of cash. The whole economic
system is flush with cash. Earnings
warning season is over. Earnings
reporting season is here, and earnings reports usually meet or beat
expectations. 

We’ve been through
several weeks of gloom. My gut feeling is
it’s time for the mood pendulum to swing the other way for a while.
So if the market breaks its trendline to the upside, we would advise
closing all bearish positions and going long, as any rally (with good volume)
will probably trigger even more buying.