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Is Rovi Ready for a Risk Reversal?


There's a lot of bullish options activity in this beaten dog.

Rovi Corporation (ROVI), a Santa Clara, California, digital entertainment firm, has seen its stock pummeled in recent weeks, dropping some 20% from $34.50 to $28 over the past two weeks. But even as shares drift lower today, there's unusual, and decidedly bullish, option activity.

The trigger for the precipitous fall seems to have been a mixed, actually contradictory, research note from Kaufman Bros. on October 14 that was then picked up by Barron's. In it, analyst Todd Mitchell raised his price target to $37, but also said the stock was "priced to perfection" and that recent gains had more to do with takeover or M&A speculation than fundamentals or value.

Breaking Down the Risk Reversal

Whatever the catalyst for selling the stock is, it's been a free fall, with shares trading around $27.50 and closing in on filling a gap left at the $26.30 back in early August. It looks like one strategist is taking an aggressively bullish stance in the options market.

On Wednesday, option volume is running about six times the daily average and a single strategy known as a risk/reversal is what's driving the activity. In this case, someone has sold 5,000 of the December $25 puts at $0.65 a contract and simultaneously purchased 5,000 of the December $30 calls for $0.90 a contract. That's a $0.25 net debit or a cost of $125,000 for the 5,000 contract position.

The position starts with a 0.57 delta, meaning each reversal is the equivalent of being long 57 shares, so the 5,000 contract position starts with the equivalent 285,000 shares. The delta will increase as shares rise, though it will also turn decidedly negative if the stock slips below $25 a share. In a stock like Rovi, which only trades about 1.3 million shares a day, this is a sizable stake and considerable exposure.

The benefit of using a risk/reversal rather than the outright purchase of stock, aside from the obvious leverage, is that the risk/reversal provides some price cushion in terms of where losses will be incurred. Given the $0.25 net debit, the position has a breakeven point of $25.25 and $30.25 a share at expiration.

This means the stock can decline another $2, or 7.5%, before a loss is incurred. It also means that a rally of $3, or 10%, is required to turn a profit. Of course, a price move in either direction prior to expiration could allow one to close the position, for better or worse.

Is it Actionable?

I usually don't like to ride the coattails of unusual option activity in my own trading decisions because you never really know what the other parties' full position is or if they can even be considered smart money. But in this case, with the stock approaching technical support near the $26 level, it might be worth further investigation.

The company is slated to report earnings on November 9 and expectations are for top-line growth of 10% to $130 million and a bottom-line increase of 42% to $0.37 per share. This would give Rovi a relatively modest P/E of 13 times forward earnings.

For those ready to carry the risk of a reversal, it might make sense to look at a simple vertical call spread such as buying the December $25 call and selling the December $30 call for a net debit of around $2.25 for the spread.


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No positions in stocks mentioned.

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