CMG: Overreaction to Einhorn?

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At the Value Investing Congress on Tuesday, fund manager David Einhorn made a short case for shares of Chipotle Mexican Grill (CMG), arguing that Yum! Brands! (YUM) was going to succeed at taking market share from the burrito-maker with its new Cantina Bell line at Taco Bell.

Shares fell 6% in the moments after it became clear that CMG was Einhorn's target, as he has developed a reputation for successfully shorting high-priced stocks. The stock closed down 4% on the day, and short option-implied volatility rose 8%. CMG is down nearly 14% over the last twelve trading sessions, and is down more than a third from its high set back in April.

fig. 1. CMG 5-day Prices and November Implied Volatility
Source: Livevol


Option prices were well-bid even before today's news, and traders took advantage of the spike in implied volatility today to reposition themselves. Nearly 52,000 option contracts traded, 2.7 times the average daily volume. However, in spite of the bearish price action, traders were actually net sellers of premium, selling more in call options than they bought in puts. For instance, in the largest single trade on Tuesday, during the flurry of late morning activity one trader sold the weekly October 310 calls expiring on Friday 395 times for a price of $1.50. The stock would need to recover most of Tuesday's losses over the next few sessions for those calls to expire in the money.

fig. 2. CMG 30-day Implied Volatility vs. 60-day Implied Volatility
Source: Livevol


Richly priced options extend beyond the weekly series. Some skeptics may wonder whether CMG options merely reflect the fact that earnings are expected just before October options expiration. To test whether the current bid in CMG options can be plausibly attributed to earnings, we plotted the 30-day implied volatility against the current 60-day estimate over the last two years. As evident from the attached chart, short-term upside spikes in the ratio measure have coincided with the days just prior to earnings announcements, consistent with normal expectations.

In the current market, however, one month implied volatility is elevated well beyond its normal relationship to the two-month estimate, suggesting that options are richly priced beyond what pending earnings would justify. Today's price swing was felt across the options term structure, but it looks like traders may have overreacted to the CMG news.

We will sell October options and buy November options at the same strike. The resulting calendar spread is expected to profit if CMG volatility declines over the next few weeks. We do not expect a large drop in October implied volatility as the options should stay well bid into earnings; rather, we are looking to profit from a reversion to the normal pre-earnings ratio between first and second month options. We will exit the spread before earnings are announced on October 18th at the latest.

Trades: Sell to open CMG October 300 puts at $11.30 and buy to open CMG November 300 puts for $14.90.

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At the time of publication, Jared Woodard held no positions in the stocks or issues mentioned.