By Chris Ebert

Pfizer Inc. (PFE) stock has been on a roll over the past two years, with the share price currently up 50% since August 2010. A purely technical analysis indicates that the stock may again be getting ready to rally once the recent minor pullback is complete.

An alternative method for analyzing stocks involves studying the performance of stock option trades. Option premiums are determined by implied volatility, which is just a fancy way of saying that emotions determine whether or not option trades are profitable. It stands to reason that 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

One of the most common option trades, the covered call, can be studied in order to determine whether or not traders are likely to feel bullish. The seller of an at-the-money covered call option receives a premium, and will therefore make a profit if the stock price rises, remains steady, or even falls slightly – generally, when traders are bullish. Covered calls only result in losses when prices decline faster than expected – generally, when traders are bearish. The time to expiration of the covered call is important; too much time yields a trade that reacts too slowly to change, while too little time yields a trade that may swing wildly from week to week. Covered calls opened 112 days prior to expiration react quickly enough while smoothing out weekly changes that have little effect on the overall trend.

It might appear obvious that traders should feel bullish about Pfizer, given the performance over the past two years. It doesn’t take an analysis of stock options to determine that the bulls are in control. Nevertheless, the following chart is presented as verification that covered call performance reveals that Pfizer traders are currently bullish.

The strength of bullish emotions can be determined by a different type of option trade, the long call. When an underlying stock price rises fast enough to overcome the premium required to purchase an at-the-money call option, 112 days before its expiration, traders are likely to feel confident in the strength of the stock. Long call options on Pfizer are currently profitable; therefore traders are likely to feel confident in the strength of the stock.

Regardless of covered call performance indicating bullishness, and long call performance indicating strength, it is possible for trader’s emotions to be unjustified. This condition can be measured by another type of option trade, the long straddle. A long straddle is an expensive trade to open, since it requires the purchase of both an at-the-money call and put option. When such a trade, opened 112 days before expiration, results in a profit of more than 4% it is an indication that traders were taken by surprise – the stock price moved more than most of them expected. This can be a dangerous condition because the stock price has come too far, too fast, to make traders comfortable, and often results in a correction. When a long straddle results in a loss of more than 6%, it is also an indication that traders were taken by surprise – most expected the stock to move and it didn’t. This also represents a dangerous condition because traders are then likely to drive the stock to make a big move, but the direction of the move is often not easily predictable.

Straddles on Pfizer continue to perform within normal limits, as they have for much of 2012. From a purely technical standpoint, given the bullish emotions portrayed by covered calls, and the strength shown by long calls, Pfizer currently appears to be a profitable stock to buy. However, any decline in the share price below $21.80 in the next few weeks would alter the options analysis in a way that would make buying much less preferable.

On a final note, traders who do not yet trade options may want to take a second look at the covered call chart above. Covered calls are fairly simple trades, and almost anyone can trade them if they meet some very basic requirements from a broker. While covered calls are not always profitable, Pfizer is a textbook example of how covered calls can produce consistent income when used correctly. Covered calls are profitable when opened in the right market, on the right stock. Except for a few months in 2011, Pfizer has consistently been the right stock in the right market.

Option position returns are extrapolated from historical data that, while reliable, cannot be guaranteed accurate. It is not possible to match the exact performances shown, because the strike prices and expiration dates used in the calculations will not always be 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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