Analysis: J. C. Penney Outlook Based on Debt Trading and Options Flow

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Several months ago on Options Profits we discussed how J. C. Penney (JCP) option flow was beginning to indicate dire concern about the retailer's prospects, with January 2015 5 strike 'DOOM' (deep-out-of-the-money) puts bought for $1 when shares were near $12. Those puts were notable because they could very simply be looked at as a default estimate based on a paper by the highly regarded Professor Peter Carr. Put simply, paying $1 for a put that can only be worth $5 (if shares go to zero) indicates a rough 25% probability of default.

JCP shares shed a few dollars after our note, and while they recovered from the $6.50 range into year-end things have turned ugly again and share price hit a multi-decade low yesterday and closed at $5.77. Those Jan15 5 puts are the largest position open, with more than 107,000 contracts outstanding and their closing price of $1.57 represents an impressive return for the buyer.

Implied vol and put/call skew in JCP spiked as well- to clear 'panic' levels with 118% implied vol and a massive premium in the downside puts, partly due to difficulty shorting shares.

In this case, an important part of the puzzle is outside the realm of most stock and options traders expertise as the debt JCP carries in the form of commercial paper and bonds. At this point (JCP down a few cents Friday morning) traders involved in JCP debt are likely to have the best picture of what the market makes of JCP in the long term.

Debt trading is less transparent than equity or options, but one trader I spoke with said the debt was implying a better chance of survival for JCP than he would have expected so I may look for an upside trade in JCP. The super-juiced vol and skew make puts the best sale, which may sound dicey, but with shares near $6, there is only that much risk remaining in the stock. An upside call position is also worth a look, with that steep skew and defined risk working in the buyer's favor.

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At the time of publication, Henry Schwartz held no positions in the stocks or issues mentioned.

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