Sirius XM's NASDAQ 100 Inclusion: Considerations for the Expected Rally

 |  Includes: NDAQ, SIRI
by: SA Editor Rocco Pendola

Sirius XM (NASDAQ:SIRI) longs and shorts have different types of nervous anticipation heading into Monday's trading. This, of course, is because of the NASDAQ OMX Group (NASDAQ:NDAQ) announcement from late Friday that it will include Sirius XM in the NASDAQ 100 index, effective July 15th.

For longs, it's akin to the butterflies you feel ahead of an interview for a job you know you're getting. The shorts, meanwhile, see the writing on the wall; they just do not know exactly how bad the damage will be. As is often the case, a narrative from Sirius XM cornerstone Bruce Springsteen puts that sinking feeling into words better than most:

And everybody's wrecked on Main Street from drinking unholy blood

Sticker smiles sweet as gunner breathes deep, his ankles caked in mud

And I said "Hey, gunner man, that's quicksand, that's quicksand that ain't mud

Have you thrown your senses to the war or did you lose them in the flood?"

-Springsteen, Lost in the Flood

Bruce did not write that song with Sirius XM burning the shorts in mind, but if he was smart enough to buy SIRI call options in anticipation of earnings, he might revel in its application.

Not only will the NASDAQ 100 news profoundly impact the near- and long-term stock price, it will throw the options market into a tizzy first thing Monday morning. In this article, I provide insight into what might happen to Sirius XM calls Monday morning. The following examples and thoughts use theoretical models and textbook cases, therefore they might not always reflect what happens in reality.

I visited the Chicago Board Options Exchange (NASDAQ:CBOE) website and used the iVolatility options calculator to model what might happen to Sirius XM call options under different scenarios first thing Monday morning and in two weeks time, assuming the most optimistic predictions come true.

Heading into these projections, it's important to understand a little bit about implied volatility and how it might change as the options underlying stock -- in this case SIRI -- reacts to the news. Plain and simple discussions of volatility do not come much better than this example from the website of Seeking Alpha contributor optionMONSTER's website:

click to enlarge image

Click to enlarge

It's also important to remember that deep in- and out-of-the-money options tend to have higher implied volatilities than at-the-money options, thus the "volatility smile" concept. Using the above-referenced math and the SIRI September $2.50 calls that I hold and have written about, we can expect SIRI to move 3.4 percent or less per day 68 percent of the time. A 3.4 percent move in SIRI from Friday's closing price of $2.221 puts it at roughly $2.30.

Below I model theoretical options prices and anticipated implied volatility in various SIRI calls with the highest open interest using data from iVolatility's calculator.

Contract (All calls) Midpoint Price (IV), Friday's Close Theoretical Option Price (IV) on 3.5% increase to $2.30, Monday Theoretical Option Price (IV) on 10% increase to $2.44, Monday
Jan 2012 $2.00 0.42 (49%) 0.48 (49%) 0.59 (50%)
Jan 2013 $2.00 0.66 (53%) 0.72 (53%) 0.82 (53%)
Sept 2011 $2.50 0.11 (55%) 0.14 (55%) 0.20 (54%)
Jan 2012 $3.00 0.12 (51%) 0.13 (50%) 0.18 (51%)
July 2011 $2.00 0.24 (78%) 0.31 (91%) 0.35 (88%)
Aug 2011 $2.00 0.29 (53%) 0.35 (55%) 0.46 (49%)
Click to enlarge

What these models do not take into account is supply and demand. Undoubtedly, traders and investors will pour into SIRI calls on Monday morning, relative to normal volumes. When implied volatility spikes, options prices get expensive. This is why you often hear options observers refer to "selling volatility" as opposed to buying it. If traders and investors flock into SIRI calls Monday morning on the expectations of considerable price increases in the underlying stock going forward, implied volatility in SIRI calls may rise more than the models allow for, resulting in rich option premiums.

Simply put, if you own SIRI calls heading into the expected rally, you're best positioned to profit. You got it right by buying volatilty at low levels and, eventually, selling it at high levels. If you do not own calls and intend to dabble, be careful which ones you select. Remain weary of buying the volatility experienced options traders will look to sell, particularly on those alluring, deep out-of-the-money calls you often hear referred to as "lotto tickets." They get the name for a reason.

Disclosure: I am long SIRI stock as well as SIRI September $2.50 call options.