By Chris Ebert
An analysis of option trades on General Electric (GE) shows two types of emotions are likely to be present among traders. GE stock has been trending upward for nearly a year. While recent performance has left traders strongly bullish, the quick pace of the uptrend has likely left many felling that a correction is overdue. These mixed emotions may cause GE to find near-term resistance at the current $23 – $24 level.
Because option premiums are based on emotions, the profitability of these trades is highly dependent on emotions as well. The profit or loss of option trades can therefore reveal the emotions of traders. If the emotions are known, the decision of when to buy or sell a stock can be made with more confidence. A study of stock options can therefore be helpful, even for traders who do not trade options or understand how they function.
- Covered call performance reveals whether traders feel bullish or bearish
- Long call performance reveals whether traders feel a stock is strong or weak
- Long straddle performance reveals whether traders feel surprised
Covered calls opened with a strike price that is the same as the GE share price (often called the at-the-money strike price), and opened a moderately long time before expiration, in this case 112 days, have returned a gain every week in 2012. The profitability of these trades occurred despite several corrections in the uptrend in which the share price declined up to 10% off of weekly highs before resuming the trend upward.
When covered calls are profitable, traders tend to feel bullish. Covered calls are currently profitable with the GE share price near $23, and they will remain profitable unless the share price falls below $21 in the next few weeks. A decline below the $21 level in the next few weeks, it would very likely represent a significant switch to bearish sentiment.
Just because the performance of covered calls indicates that traders are currently bullish does not mean that prices will necessarily rise. It is therefore helpful to look at the performance of another option trade, the long call, in order to determine the strength behind those bullish emotions.
Long calls on GE opened at-the-money, 112 days prior to expiration, have been profitable since late August. When long calls are profitable, traders tend to feel strength behind their bullish convictions. Long calls will remain profitable unless the share price declines below $22 in the next few weeks. A decline below the $22 level in the next few weeks would represent a loss of strength in traders’ bullishness.
Even though covered call performance indicates bullishness, and long call performance currently indicates strength behind that bullishness, there is still no guarantee that prices will rise. It is therefore helpful to analyze the performance of a third type of option trade, the long straddle, in order to determine whether traders feel surprised by the current price of GE shares.
Long straddles opened by buying an at-the-money call option and a put option, at the same strike price, 112 days prior to expiration have been highly profitable recently. These profits do not represent a normal condition, but instead reveal that the share price moved much further, much faster than many traders expected.
Often, but not always, excessive profitability of long straddles is an indication than many traders may feel that the stock is due for a correction in the current trend. That does not mean a correction is imminent. However, given that many traders are likely to feel surprised by how fast GE shares have climbed in recent weeks, any negative news surrounding the company (or the broader market) could trigger those traders to sell.
Over the next few weeks, any price of GE shares above about $23.75 would cause long straddles to exceed the maximum 8% profit that may be considered normal. An increase in the share price above $23.75 in the next few weeks could trigger a correction. Any decline below about $20.50 would cause those same trades to exceed the maximum 12% loss that is normal. A decline below the $20.50 level in the next few weeks could trigger a breakout. Such a breakout could either be to new multi-year highs, or back towards recent support in the $19-ish area.
Possible option trade based on the options analysis:
While no single option trade is suitable for all traders, the following is presented for consideration. Given the above analysis, in the absence of some surprisingly good news, it appears unlikely that the GE share price could climb much above $24 in the next few weeks. It also appears that even at the current price of $23, some traders may be ready sell on the slightest bit of bad news.
BUY 10 $22 Nov. 17 Calls @ $1.20 per share = $1,200.
SELL 20 $23 Nov. 17 Calls @ $0.55 per share = $1,100.
If GE shares do experience a correction and decline below $22, everything expires worthless. The $1,100 premium received on the $23 calls offsets all but $100 of the $1,200 premium paid on the $22 calls.
If GE shares remain between about $22 and $24, there will be a profit. Maximum profit is $900 when GE is $23 on November 17th.
Losses are possible if the share price rises above $24, however they can be limited by closing the trade early if the share price begins to approach that level.
Note: Performance of option trades is extrapolated where the necessary strike prices and expiration dates were not available in actual trading.
The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”
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