Is Rovi Ready for a Risk Reversal?
There's a lot of bullish options activity in this beaten dog.
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.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter