Thursday, October 10, 2013

Importance of Evaluating Option Prices and Some Hyped Stocks

Well INFY results are around the corner and as usual a lot of traders are jostling up to build option straddles as for the last 10 quarters in a row, INFY results day has been eventful with a 10% Gap-Up / Gap-Down on open and then a follow-up with another 8% to 10% in the same direction for the subsequent 2 weeks.

Most traders want a quick-gun murugan trade with 100 points on the options straddle on open [and I have myself garnered that for 8 quarters in a row now ;)] However, What has intrigued me the most is the blind lapping up of these options by retail traders without going through the intricacies. Under normal circumstances, such things are fine but a lot of retail traders miss out on one critical point that is IV - Implied Volatility of the option. With retail traders queuing up like this, the Implied Volatility of Options shoots up big time and for the last 2 quarters, we have seen Implied Volatility of INFY options go as high as 80% to 90% a day prior to the results

What does this mean? With Implied Volatility shooting above 80%, one needs about 12% move in any single direction to BREAK-EVEN on the options spread cost. Only the move beyond 12% can yield some profits thereby making it a less meaningful trade. I suspect that the same thing is going to happen today by the end of the trading session and hence retail traders are advised to step aside on this trade. The best way to play the INFY result is to buy the options straddle well before the Implied Volatility shoots above 55% OR wait for the result play to take place and after option prices rationalize and then take a position accordingly.

For if one falls prey to buying the options with such high Implied Volatility, then you are only making the brokers and options writers richer. (I already have 2 lots of OTM INFY options straddles bought when the Implied Volatility was at 45% and if I manage to make 100 points on the spread when the IV goes high today, I will liquidate 1 lot today itself without waiting for the result!)

Other updates are related to some hyped up stocks and hyped up IPOs coming up

Just Dial: The stock is following the script of Educomp. The only saving grace is that retail traders are protected of getting their cost for 100 shares when the price goes on a tailspin provided that happens within 12 months of collapse [Educomp took 3 years to collapse 95% so expect the same time frame]

Jubilant Food: The stock is trading at over 65 times PE and this is not at all acceptable. Stocks like HUL, PnG, ITC trade at about 35 times PE and Asian Paints trades at about 42 times PE (Very high and over-valued actually) When the bubble will burst on Jubilant Food will burst I don't know but it will burst for sure. Indians consume far lower a share of pizza than other foods. Moreover, as the pizza space expands, you will have strong competition from Pizza Hut, Papa Jones, Smokin Joes etc so the market space will be crowded.

Jubilant Food at 30-35 times PE is still ok but definitely not at current levels.

MTEducare: Another Aptech / NIIT in the making and expect the stock to crash about 90% from CMP in 3 years time. PE is ok at about 24 times but a realistic valuation even in the recession proof education sector, the market space is crowded and anything beyond 8 or 10 times PE is over-valued.

Upcoming IPOs in the next 12 months
Aakaash - The training academy for JEE/NEET; expect an over-hyped IPO and price follow up but will meet with the same fate as that of NIIT/Aptech/MTEducare

Flipkart: Good e-tailing model and whilst it may soon cross revenues of USD 1 billion, profits in the e-tailing segment are less than 4% of turnover and they come with high expenses. Moreover, with Amazon Kindle and Google Playbooks crowding the e-commerce space with tablets and smartphones, the margins pressure on Flipkart will be high [Remember Subhiksha???]

The media will keep hyping up these stocks just as it did for Shree Renuka Sugars, Optocircuits, Delta Corp, Educomp, Gitanjali Gems, PC Jewellers etc and then at some point of time [after 80% crash] say that these are dead stocks and one should not look at them!

As retail investors, one should avoid these hyped counters as they 'seem' lucrative in the short term but in the long run, ruin investors. Whilst returns might be average market returns, one should stick to the indices and some time tested stocks and always invest in tranches.

A few days from now, we will either see a repeat of the crash of stocks OR a break-out [2 consecutive closes above 6280 on Nifty spot] So just wait for the crash or the breakout and then enter.

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