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Cheap Options, Cover Stories, and the Contrarian Mindset

Reviewing two important contrarian investing principles

by 12/3/2013 11:11:26 AM
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The following is a reprint of the market commentary from the December edition of The Option Advisor, published on Nov. 21. For more information or to subscribe to The Option Advisor, click here.

I don't often focus on three-month rolling returns (I tend to focus on full quarters and "quarters to date" and reserve my "rolling" periods to year-over-year returns). But for "laughs and giggles" (my explanation -- others may accuse me of not having enough of a life outside the stock market), by way of the impressive screening capabilities at finviz.com, I took a look at the top and bottom performers for the past quarter and found some interesting situations.

At the top of the list of quarterly gains (at 91%) was Nokia (NOK), and I was immediately reminded that: 1. We have an open long recommendation in Nokia January calls in our Options Under $5 service, and 2. I had recently reviewed the premium levels for Nokia options, and my conclusion was they were very cheap, indeed.

This led me to produce the accompanying chart for this space (courtesy of TradeMonster, click to enlarge). And this chart is as strong an illustration as I could imagine providing you of how sometimes the options market can digest input in the form of strong price action accompanied by a pretty high level of volatility, and deliver output consisting of a big yawn (with this yawn being in the form of low implied volatilities, which translates to "These options are sure cheap!"). The story is laid out pretty clearly on the chart, but an even shorter summary is: "You can buy NOK options at premium levels last seen back in August, before the Microsoft (MSFT) deal and while the shares had been languishing for over a year in a $3-$5 trading range."

Daily chart of Nokia (NOK) since May 2013

Does this mean you should now go out and buy NOK calls? The answer is not much different than would be my answer to any question of this nature. You should buy Nokia calls if you feel you have a credible upside forecast for the stock that will play out over the life of your call option in such a manner that the profits you'd achieve on your calls (if you were correct) would result in the trade being worth the risk associated with less favorable share price outcomes. But there is a difference in the case of Nokia (at least as I write this), and this difference can be far from trivial. Namely, the bar for achieving profits on your calls has been lowered because NOK options are cheap. Put another way, at every share price level (assuming a substantial rally in Nokia over your holding period), the profits on your calls will be higher than they would otherwise have been if the calls had been priced at higher levels of implied volatility. Unlike some option traders, I don't reject the idea of buying "rich" options when I feel my price forecast is aggressive enough and compelling enough. But our lives as traders are sure made a lot easier when we are trading a "platinum quality" price forecast and at the same time buying "two-bit" option premium.

And while on the subject of noteworthy quarterly performance, was it simply a coincidence that I had become aware that Fortune magazine had conferred on Elon Musk of Tesla Motors (TSLA) the designation of "Businessperson of the Year" within hours of checking out the bottom performers for the most recent quarter on that same finviz.com screen? I don't want to make too much of the fact that TSLA posted a 24.5% loss for this quarterly period, what with the fact that the year-to-date gain in the shares is still an eye-catching 260%.

But this quarter- vs. year-to-date performance dichotomy did remind me of a couple of important principles related to contrarian investing as it might particularly relate to major media articles. 1. A high-profile cover story is usually months in the making. In other words, the decision to bestow this honor on Mr. Musk may well have been made at or near Tesla's actual share price peak. Which illustrates the principle that the draw of a stock that has "gone parabolic" (especially if there is a media-friendly story associated with it) is just about irresistible, at the same time as the chances the stock is in the process of putting in a major top are very great. And 2. When a positive media article (in particular, a "cover story," though this concept has been losing some meaning as such information is most frequently being accessed electronically) appears AFTER a stock is down substantially from its highs (preferably six months or longer after such a top), the bearish contrarian implications are compounded.

My favorite example of such a belated situation was a bullish cover story on AOL Time Warner that appeared in a prominent financial weekly a couple of years after that disastrous merger -- the one that kept playing "Can you top this?" on the disaster front until it finally was ignominiously disbanded. Needless to say, the biggest leg of the plunge in AOL Time Warner shares was to be reserved for the period after this belated bullish article. (I also recall at the time that the Wall Street analyst community had still barely budged in terms of taking this company off their "buy" lists.)

Why are such belated bullish media pieces -- written long after a highly favored stock has topped -- such good bearish contrarian fodder? Because in theory, by that time we should no longer be blinded by the skyrocketing share price when attempting to objectively assess the company's prospects. But this also takes us to another topic (too far afield for detailed discussion today) that goes to the heart of what I see as the fatal flaw of so-called "pure fundamental analysis." A hint regarding this fatal flaw? Actually, if you've ever heard an analyst explain that a stock currently trading at 30% or 40% off its high (at which level his firm had rated the stock a "buy") is now "an even better buy based on valuation," you probably have a good sense for the flaw.

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