By Chris Ebert

An analysis of stock options reveals that traders of Cirrus Logic (CRUS) are likely to feel strongly bullish. The analysis also shows that the stock was way overdue for a correction. The recent decline from the $45 highs of early September should go a long way to satisfy those traders who felt that Cirrus had simply risen too far, too fast.

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

For a complete description of the methods employed to complete the options analysis check out this recent analysis of Cooper Tire (CTB) options.

Covered calls opened with a strike price that is the same as the CRUS 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 some significant corrections in the share price. When covered calls are profitable, traders tend to feel bullish. Because these trades will remain profitable unless the share price falls below $26 in the next few weeks, if that $26 level is reached it would very likely represent a significant switch to bearish sentiment.

Long calls opened at-the-money, 112 days prior to expiration have also been profitable for every week of 2012, although there were two occasions on which they only broke even. 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 $32 in the next few weeks. So $32 represents a significant level where traders will begin to lose conviction in their bullishness.

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 most traders expected. The recent correction has returned straddles to a more normal range of profitability.

It is quite possible that the pullback to $38 represents a sufficient correction to satisfy most traders. But further analysis of long straddles also indicates that the share price could fall as far as $32 in the next few weeks before reaching a level that would indicate the stock was due to break out of its recent trading range. If that $32 level is reached, it would likely be followed by either a re-test of the recent $45 highs, or an all-out selloff that might push the shares back below the $30 level where the previous breakout occurred this past July. So $32 is an important price to watch for, not only because the performance of long straddles suggest a possible breakout at that price, but also because the performance of long calls suggest a drop in bullish strength at that price.

Possible option trade based on the options analysis:

While there are many possible option trades that could be opened given the above analysis, the use of protective puts is definitely one to consider. For traders willing to take a chance on buying shares at the current $38 level, given the importance of the $32 level in marking a change in short-term sentiment, protecting those shares by buying puts at the $32 strike with the October 20 expiration is one possible strategy. Given the relatively low premium on those options, it is possible to over-protect the shares, that is to buy more than one contract for every 100 shares of stock.

Overly Protective Put example:

BUY 100 SHARES CRUS @ $38.00

BUY 3 $32 OCT 20 PUTS @ $0.40

This option trade can be thought of as a high-deductible triple-indemnity insurance policy. The high deductible applies because there is no protection for the shares unless the price falls below $32, so the insurance premium is much lower than the $2.00 per share required for a zero deductible $38 strike put option. The triple-indemnity applies because if the share price does fall below $32 the insurance benefit is then three times the amount of damage, less the deductible.

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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