Wednesday, August 26, 2009

Farmer in the DELL

Along with the VIX, Dell Inc. (DELL) also received some face time in Friday night’s Options Action. With Dell earnings scheduled for Thursday night after the bell, the Options Action crew highlighted a few earnings plays. The consensus across the panel was Dell options weren’t pricing in that much of a move, so both strategies recommended were of the option buying variety. Remember, from a volatility stand point we prefer to buy what seems to be underpriced options and sell those that seem overpriced. One pundit recommended a long strangle, while the other a straight call option purchase.

Did they get it right? Are options pricing in a small or large move? Let's analyze the volatility chart:

[Source: IVolatility]

Current 30 day historical volatility sits around 40%. Implied volatility is around 45%. So we do have IV pricing in a small uptick in volatility, but not much. When comparing current implied vol levels to its 1 year historical range it is sitting close to 52 weeks lows. With that backdrop, yeah I suppose you could say options aren't really pricing in that much of a move, but it certainly seems justified given the implosion in realized vol we've seen not only in Dell, but across the board in most all stocks.

On to the recommended strategies...

Pundit #1 recommended a Sep 14-15 strangle purchase. Remember with buying straddles or strangles, you want to see inexpensive options and expect a large move in the underlying. These two criteria foster a greater likelihood of a successful trade. Let's run the numbers.

Long Sep 15 call $.57
Long Sep 14 put $.38
Net Debit $.95

[Source: EduTrader]

Assuming you held the strangle until September expiration, you'd need to see at least an 8% increase or 11% decrease in the stock price just to break even. With the dampened reactions to earnings announcement we've seen so far this earnings season, long strangles have been a rare winner. A fact that I'm sure doesn't instill confidence in those willing to go out on a limb and buy strangles.

So what about the straight call purchase? Well, purchasing one side of the strangle certainly makes the trade cheaper, which decreases the amount of risk. It also lowers the breakeven so Dell doesn't have to rise as much to profit. I've never really been fond of directional bets into earnings as I don't really think anyone has much of an edge making that bet. It's more of a coin flip in my opinion. But I suppose if you have a bullish bias, the long call would trump the strangle.

As for myself, I don't tend to play cheaper stocks like Dell as much and not sure I see much of an edge either way into earnings. So I'll be sitting this one out.

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