JAZZ Simply Came Too Far Too Fast

At one point early this October, Jazz Pharmaceuticals (NASDAQ: JAZZ) share price was up 58% year-to-date, including a rise of 25% in September alone. While that is great for shareholders, it also presents a problem; the stock price has risen too quickly for traders comfort.

Stock prices tend to increase when a company is perceived as being more profitable than it had been previously, or is on the path to higher profits. The rising stock price attracts new buyers, which in turn adds momentum to the climb. Higher momentum then attracts additional buyers. In some cases, buyers are only buying because everybody else is doing it. A stock can become a fad.

There are many technical indicators that can help determine when a stock is overbought. One of those is an analysis of an option trade known as a Long Straddle. Since early September, Long Straddles on JAZZ have been indicating that the stock was “due for a correction”. Now that October has brought that correction, there is no need for further correction; at least not as far as option traders are concerned. Of course, it is possible for the price to continue to decline for other reasons such as poor news. But JAZZ is no longer a fad, and for some traders this could be a buying opportunity.

JAZZ Options Analysis

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 JAZZ share price (often called the at-the-money strike price), and opened a moderately long time before expiration, in this case 112 days, have consistently returned gains every week for the past two years, with the exception of a few minor losses this past May and June.

When Covered Calls are profitable, traders tend to feel bullish. Covered calls are currently profitable with the JAZZ share price near $55. In spite of the pullback off of the September highs, the continued profitability of covered calls indicates that JAZZ traders are currently bullish.

Just because the performance of Covered Calls indicates bullishness 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 JAZZ opened at-the-money, 112 days prior to expiration, have also been profitable every week in 2012. 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 $51 in the next few weeks. A decline below the $51 level in the next few weeks would represent a significant loss of strength in JAZZ 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 JAZZ 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 JAZZ shares have climbed in 2012, especially in September, the recent pullback was to be expected.

Over the next few weeks, any price of JAZZ shares above $62 would cause long straddles to exceed the maximum 8% profit that may be considered normal. An increase in the share price above $62 in the next few weeks could trigger another correction. Any decline below about $50 would cause those same trades to exceed the maximum 12% loss that is normal. A decline below the $50 level in the next few weeks could trigger a breakout. Such a breakout could either be to re-test the recent $60 highs, or back towards prior support in the $48 – $49 range.

Conclusion

Using past performance as a guide, once the Long Straddle performance on JAZZ returns to normal after having previously indicated that the stock was due for a correction, it often then moves to a point where it is due for a breakout. There are two possible ways that this can occur: The stock quickly declines to the $50 – $51 range in the next week or so, or it remains in the $55 range for an extended period of a month or so. If it quickly drops to $50 and then bounces, that would be a strong indication that support had been tested and the uptrend was likely to resume. If it moves sideways at $55 for several weeks, that would be a strong indication that recent gains were being digested ahead of the next leg up. Either way, an indication is not a guarantee, and there is always the possibility that the next leg is down.

Possible Option Trade Based on the Options Analysis:

While at-the-money Covered Calls on JAZZ have a long history of profitability, these particular options are very lightly traded. It would seem that buying 100 shares of JAZZ at $55, and selling one $55 Call option might be a trade with a high probability of turning a profit. However, the lack of liquidity in JAZZ options makes it unlikely that they could be traded at a fair price, if at all. A trader of a Covered Call could potentially get stuck in a losing trade with no way out until the option expired, if the trader lacked the ability to uncover the Call.

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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