Holidays Bring Options Opportunity

The U.S. boasts a population of world-class shoppers, who have buttressed the economy for the last few years with a seemingly indefatigable appetite for goods and services.

But even the best of champions, though the heart might still be willing, inevitably need to rest, and there is growing evidence that high energy prices and only modest wage gains are sapping the consumer's ability to keep up the record pace of spending.

Despite the fact that retail sales figures have been trending lower for the last three months, and fuel prices, which act as a tax on the consumer, remain near record highs, retail stocks have performed surprisingly well of late, with both the Retail HOLDRs ( RTH) and iShares Consumer Cyclical Sector Index ( IYC) approaching 52-week highs in Wednesday's euphoric postelection rally. This could leave retail stocks vulnerable to a selloff and volatile trading as we head into the all-important holiday shopping season.

The implied volatility on the options on these two retail-based exchange traded funds, or ETFs, is about 16%, which is near the low end of their near 52-week range. This presents an opportunity to establish a low-cost/low-risk bearish position through the purchase of inexpensive put options. The low implied volatility level stands in contrast to the fact that retailers are entering their most volatile time of the year in which weekly sales reports can cause significant price movement.

With the shares sitting near 52-week highs, the risk seems greater for disappointing news to trigger a sharp pullback. Buying put options gives you a bearish base from which to trade this group during what can be an active period.

Flipping Stock Against Options

Establishing a bearish (long puts) position provides the possibility of making many short-term trades at no additional risk. With implied volatilities at low levels, the ability to profitably "flip" stock a sufficient number of times to offset the time decay of the long options becomes a very attractive trading tool. Here is a basic example of how trading the underlying stock against an existing option holding might work:

Assume with XYZ Retail Corp. trading at $50, one buys 10 of the December XYZ $50 puts. With more than six weeks remaining until expiration and an implied volatility of 17%, the puts might have a value of $1.15 per contract, meaning the 10 put contracts cost a total of $1,150. If XYZ shares fall to $47 (let's say there was a disappointing weekly sale), the value of the puts would climb to $3.15, giving the 10 long-put position a value of $3,150.

You now have several choices: Sell the puts and pocket the $2,000 profit, or you could buy 1,000 shares of XYZ at $47, locking in a profit of $1,850, which is $115 less than selling out the puts but keeps the position open. Now, if XYZ were to trade a $50 per share, the 1,000 shares of stock could be sold to secure a $3,000 profit on the long stock trade. And you still would own the 10 put options, which -- assuming there are now just three weeks remaining until the December expiration -- would retain an approximate value of 90 cents, or $900 for the 10 contract position. At this point, if you sell out the puts, the net profit would be $2,750, or 37% greater than if you had simply sold out the puts on the initial dip. And remember, you incurred no additional risk when buying the shares against the long put-option position.

Rinse and Repeat for Healthy Scalp

The real attraction is that the process of risk-free short-term trading or "scalping" can be repeated each time the XYZ share price moves below $50. Profitable scalping actually becomes more attractive and requires a smaller price movement in the underlying as the option expiration date approaches. This is a function of the fact that an at-the-money option retains its time premium better than strikes further in or out of the money, and that its options delta is sloped.

In simple terms, once the put has moved into the money, you already have received the most bang for your buck; in the example above, the put options generated a 300% return on a 6% move in the XYZ common stock. But as the option moves deeper into the money, its price will begin to correlate on a dollar-for-dollar basis with the underlying shares. The reverse is true, too: As an option moves out of the money, its price falls less than the price of the underlying stock. In trading the stock against the option position, you are capturing the differential created by the slope of the delta, i.e., the rate of change of an options price relative to the change in price in the underlying common.

With just one week remaining until expiration, if XYZ is trading at $50 per share, the puts will still retain an approximate value of 55 cents, which means if shares decline to $49.45, you can lock in that value through the purchase of stock and have the opportunity to make another risk-free trade. If shares move back up to $50, you have just scalped another $550 profit out of the position.

Cheap Retail Options

On Wednesday, with the Retail HOLDRs trading at $96, one can buy the December $95 put for $2 per contract. This gives the put option a break-even of $93, which represents the initial level one can buy stock to lock in a risk-free trade. But because the put currently has an intrinsic value of $1, one could probably safely begin scalping a portion of the position if the RTH dips to $94 per share.

Some individual issues whose options have relatively low implied volatilities (based on their 52-week range) include Hibbett Sporting Goods ( HIBB), Coach ( COH), Kmart ( KMRT) and PetsMart ( PETM). These stocks have all had nice runs and are near 52-week highs or are approaching important resistance, which is the case with Hibbett as it fills the gap at $23 per share.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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