Also: How to use options around earnings to trade Nike's stock, which has been down in the dumps for years
Investor sentiment on an exchange-traded fund tracking oil prices is getting very bullish again - enough to flash a contrarian sell signal.
Sometimes the best course of action to take on Wall Street is the opposite of what everybody else is doing.
With that in mind, we note that the options market is flashing a new sell signal, via what's known as the put-call ratio, for the United States Oil Fund USO.
A put option gives the buyer the right to sell at a predetermined price, while a call option gives the buyer the right to buy. The put-call ratio is a sentiment indicator, as it compares the volume of puts traded with the volume of calls. A drop in the ratio suggests more demand for call options, while a rise indicates there is more put buying.
When the ratio falls or rises to extreme levels, it can work well as a contrarian indicator, because it indicates that the bearish or bullish trades may have gotten too crowded. Basically, if everyone has already bought or sold, their next move would be, respectively, to sell or buy.
The put-call ratio for USO had fallen to a low level, then started turning up in April to trigger a "sell" signal for the exchange-traded fund. While that signal took a little while to gain traction - USO didn't peak until mid-May - the subsequent "buy" signal in July was a more immediate success.
Now we are seeing sentiment get very bullish on USO once again, as the put-call ratio has descended to nearly the lowest point on the above chart.
Moreover, the ratio has turned upward to form a "local minimum" on its chart - and that is a sell signal for USO.
The action to take:
Buy 1 USO (Oct. 16) $152 put in line with the market.
We will hold this put as long as the weighted put-call ratio for USO is on a sell signal.
Trading Nike options around earnings
Nike's stock is on track to suffer a fifth straight year of declines - it has tumbled nearly 80% during that stretch and closed at a 12-year low as recently as Sept. 18. Investors will get a peek at how the company is doing when it releases its earnings report on Oct. 1 for its fiscal first quarter, which ended in August.
The accompanying two-year chart of Nike's stock (NKE) has two graphs on it. It shows the stock price on the bottom and implied volatility on the upper graph.
One can see that implied volatility increases into a spike and then plunges, creating a sawtooth pattern. Implied volatility increases as the earnings date approaches, then plunges after the earnings are announced.
It is actually something of an optical illusion, because the options are not getting more expensive in terms of price as the earnings date approaches; they are remaining the same price. That is, the option-trading "universe" prices the straddle prior to the earnings and more or less keeps it at that price until the earnings are announced. Straddles are option plays on how much a stock will move after an event, meaning they are not directional.
An option that doesn't lose value to time decay (which these don't over the couple of weeks heading into the earnings) thus has the appearance of increasing implied volatility. So every week when we publish the list of potential post-earnings moves, they are stocks that have this sawtooth pattern surrounding past earnings dates.
Our approach is to attempt to buy the shortest-term straddle possible (generally the one expiring on the Friday after the earnings reporting date) and to exit at the close of the first full day of trading after the earnings have been reported. For Nike's stock, the expiration would be Oct. 2.
Nike's earnings will be released after the closing bell on Oct. 1. The most we would pay for a near-term straddle before the results would be 6.76%. The price is expressed as a percentage of the underlying stock price. For Nike's stock, that percentage is smaller than six of the past 10 post-earnings moves.
Send questions to lmcmillan@optionstrategist.com.
Lawrence G. McMillan is president of McMillan Analysis, a registered investment and commodity trading adviser. McMillan may hold positions in securities recommended in this report, both personally and in client accounts. He is an experienced trader and money manager and is the author of "Options as a Strategic Investment." www.optionstrategist.com
(c)McMillan Analysis Corporation is registered with the SEC as an investment adviser and with the CFTC as a commodity trading adviser. The information in this newsletter has been carefully compiled from sources believed to be reliable, but accuracy and completeness are not guaranteed. The officers or directors of McMillan Analysis Corporation, or accounts managed by such persons may have positions in the securities recommended in the advisory.
-Lawrence G. McMillan
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