By Chris Ebert
Traders of 3D Systems (NYSE:DDD) traders are likely to feel strongly bullish. The recent pullback from the $44 level may have satisfied some traders who believed the stock was overbought. For now, any pullback in DDD would appear to represent a buying opportunity, while any price below $34 would represent a loss of bullish strength, and any price below $28 would represent a complete loss of bullishness.
At-the-money option premiums are determined entirely by implied volatility, which is just a fancy way of saying that emotions determine how expensive, or cheap, these options are. Increasing greed tends to drive call premiums higher, while increasing fear tends to drive put premiums higher. In a process known as put/call parity, greed and fear are balanced, and traders agree on a premium that represents the risk of buying or selling a particular option based upon the observed levels of greed and fear surrounding the underlying stock.
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
Covered call options are best known as income-producing trades. Since they generate income, they only result in losses when traders of a stock are bearish - when the income is insufficient to offset the decline in the underlying share price. Covered calls opened 112 days before expiration react quickly to changes in a trend while smoothing out weekly swings that have little effect on the overall trend. At-the-money covered calls on DDD are currently profitable, when opened 112 days before expiration; therefore traders are likely to feel bullish. Covered calls will remain profitable, and therefore traders are likely to remain bullish, so long as DDD shares remain above $28 over the next few weeks.
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 DDD are currently profitable; therefore traders are likely to feel confident in the strength of the stock. Long calls will remain profitable, and therefore traders are likely to remain strongly bullish, so long as DDD shares remain above $34 over the next few weeks.
Regardless of covered call performance indicating bullishness, and long call performance indicating strength, it is possible for trader's emotions to be unjustified. Traders sometimes remain bullish when a stock may actually be headed for a correction or worse, a breakout to a lower trading range. 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. The high expense tends to greatly reduce any profits. 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. A 112-day Long Straddle loss exceeding 6% often precedes a breakout below support that either confirms trader's prior fears or a breakout above resistance that completely puts those fears to rest.
Long straddles on DDD had been producing profits well in excess of 4% in recent weeks. The recent pullback off of the $44 highs back to the $38-$39 level has now returned straddles to a more normal profitability. For now it would appear that the recent selling was part of a correction that has relieved much of the previous over-bought condition. So long as the underlying price remains above $34 over the next few weeks, the selling may be considered to be a much needed correction. However, at or below $34, the long straddle analysis would indicate that the price was ready for a breakout, either above the recent $44 highs, or perhaps back towards earlier support near the $27 level.
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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