Options Update: A Covered Call on Priceline.com?

              

The online travel group has come under fire today, after Expedia (EXPE: sentiment, chart, options) was downgraded on Thursday to "neutral" from "overweight" at JPMorgan. The brokerage firm argued that increased competition and pricing wars would cut into the company's revenue and limit market share gains. Fellow travel firm Priceline.com (PCLN: sentiment, chart, options) dropped more than 2% following the news yesterday, and the shares have fallen nearly 3% so far today. What makes PCLN particularly interesting is its recent options activity.

Calls are the investment vehicle of choice among PCLN investors. The stock's Schaeffer's put/call open interest ratio (SOIR), which measures put open interest against call open interest for the front 3 months of options, arrives at 0.50, indicating that calls double puts among near-term options. This ratio also ranks below 94% of all those taken in the past year, meaning that investors have been more bullish toward PCLN only 6% of the time in the prior 52 weeks.

The mood among speculative options traders appears to be shifting, however. For instance, the security's SOIR has risen 13.6% from its March 6 low of 0.44. Furthermore, the International Securities Exchange (ISE) and Chicago Board Options Exchange (CBOE) 10-day put/call volume ratio of 3.08 reveals that puts bought to open have more than tripled calls bought to open on these exchanges during the prior 2 weeks. This ratio falls just 3 percentage points shy of an annual peak, underscoring the rising preference for purchased PCLN put options.

It is this recent spike in puts that makes today's heavy call volume even more unusual. So far, more than 76,000 calls have traded on PCLN today, outpacing the stock's daily average by more than 16 to 1, and placing the shares on our Intraday Volume Explosion List. Digging a little deeper reveals that nearly half of this volume changed hands at PCLN's out-of-the-money April 80 strike, at the bid. With open interest falling well short of today's volume, we are likely looking at some sizable call-selling activity on the equity.

The Anatomy of a Priceline.com Call-Sell Position

Filtering PCLN's April 80 call volume, only 1 block trade numbered more than 100 contracts. At roughly 10:54 a.m. Eastern time, a block of 35,000 calls crossed the tape at the bid price of $3.35. Assuming this block was sold to open, i.e., the initiation of a call-sell position, the total credit received would be $11,725,000 -- ($3.35 * 100)*35,000 = $11,725,000. The option is set to expire on April 17, meaning that the trader entering this position needs PCLN to stay below the 80 level through this date in order to retain the entire premium received.

Keep in mind that today's trader most likely already owns PCLN shares, turning this into a covered call position. For reference, a covered call involves selling one call option for every 100 shares of stock that you own. Such a strategy can accomplish 2 things. First, the premium received can increase the rate of return by providing income on the position. Second, the downside risk of owning the underlying stock can be reduced since the premium acts as cushion for the underlying stock's downside movement.

On the other hand, a naked short call position, i.e., the trader does not own the shares, is neutral-to-bearish, with the premium received not impacted if the shares suffer steep losses. However, if the shares rally through the sold strike, this trader is on the hook to provide 100 shares of PCLN for every call sold, making it considerably more risky.

In the end, both eventualities ultimately rely on PCLN remaining below $80 per share through options expiration on April 17. For some insight on the potential outcome of such a position, let's take a closer look at PCLN's technical and sentiment backdrops.

Checking the Charts

Starting with the technical outlook, the prospects for retention of the entire premium received on an April 80 call-sell position are a bit shaky. The stock has rallied more than 6% on a year-to-date basis, enjoying the support of its 10-week and 20-week moving averages since late November 2008. However, the equity was recently rejected at overhead resistance near the round-number 90 level. Since that rejection, PCLN has plummeted 14.5%, and moved back below long-term support/resistance at the 80 level in the process. Should the shares breach support at their 10-week moving average, it could be a signal that selling pressure has yet to fully unwind.

The Sentiment Drivers

With the shares in the process of pulling back from overhead resistance, the elevated levels of optimism among options players - which I detailed earlier - become a liability for PCLN. Meanwhile, short sellers are ramping up their bearish bets on the security. During the most recent reporting period, the number of PCLN shares sold short jumped by more than 7%. Currently, more than 27% of the stock's float is sold short, but if the equity continues to display weak price action, these investors will be in no hurry to buy back their positions. No hurry, no short squeeze. In fact, the stock's recent rejection at the 90 level may even embolden short sellers, thus increasing downward pressure on the shares. Such a development could negatively impact a covered call, depending on where the trader purchased the shares, while having little negative impact on a naked short call.

Finally, Wall Street analysts have doled out 5 "buys," 4 "holds," and no "sells," according to Zacks. This configuration has the potential for both upgrades and downgrades, neither of which benefit a covered-call position.

The Verdict? There are several very compelling arguments for entering either a covered PCLN April 80 call position, or a naked short April 80 call position. For the covered call trader, there is a fine line to walk, depending on what price was initially paid for the shares. Given the sentiment and technical indicators above, I would imagine that a breach of the stock's 10-week moving average could be problematic, as the next level of technical support doesn't materialize until the 70 level. That is, unless the trader bought below $70.

Meanwhile, the greatest risk to both a naked-short and a covered April 80 call is a potential rally above the 80 level. Such a feat is not out of the realm of possibilities, especially if PCLN holds firm along support at its 10-week trendline, or scores an upgrade from Wall Street analysts.

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