Morning Update

Today one stock seeing heavy option volume is Phillips 66. The biggest trade of the day was the purchase of 5,000 November 80 calls for $1.95 with the stock at 66.33. This is a bullish bet that the stock will be above 81.95 at November expiration, a 24% move higher. This bullishness comes on the heels of a recent announcement by the company that they will boost shipments of cheap domestic crudes to its refineries across the country by as much as 130,000 barrels per day. To accomplish this PSX has joined forces with Enbridge Energy Partners for rail shipments of Bakken crude to its east and west coast refineries. Shipments are expected to reach 35,000-40,000 barrels per day by the fourth quarter.

Recently the refiners have sold off as the spread between WTI crude and Brent narrowed along with the crack spread. However, as more capacity to transport and product US crude comes on line, the WTI – Brent spread should widen back out, which gives refiners like PSX a leg up on the global competition.

The export market is one of the biggest opportunities for growth among US refiners. The US is amidst a major shift from a large energy importer to an exporter, especially of refined products. Right now Mexico is the US’s largest export market for refined products because US refineries are more capable of refining heavy sour Mexican crude. I like the refiners at these levels, and am willing to buy calls on them to reduce downside risk in this volatile sector. This morning we bought MPC calls for clients, which is our top pick in the sector. We expect Marathon to do well for all the reasons PSX is set to gain, but their advantage is that they already have 8,300 miles of pipelines, which allows its 7 refiners, with 1.69 million barrels per day capacity, access to cheap Canadian and Bakken crudes.

FaceBook: 1 Year Later

Today marks the one year anniversary of FaceBook’s IPO. After a year of trading the stock is down 37%, and today one option trader is betting that the stock could trade even lower. One of the biggest FB trades today was the purchase of 8353 July 25 puts and the sale of an equal number of July 22 puts. This creates a vertical spread for a net debit of $0.55. This will profit if FB is below 21.45 at July expiration, 19% lower.

This trade could be a either a trader speculating that FB will move lower, or a long term investor that wants a cost effective hedge against a dip in the shares. The benefit of put verticals like these is the risk/reward ratio that they offer: this trade risk only $0.55 but has the potential to return up to $2.45 in profits, for a 445% return on investment. Therefore it allows FaceBook bears to gain exposure to the stocks downside without taking too much risk if they are wrong. Similarly, for someone who is long FB shares it offers the ability to hedge their losses between 25 and 22 without outlaying a lot of cash in option premium.

Despite FaceBook’s sub-par stock performance over the last year, the stock has rebounded well off of its 52-week low and has made progress in proving that they can monetize the shift to mobile. Over the last year mobile advertising has gone from non-existent to 30% of advertising revenue. But to get back to its IPO price, FaceBook will have to continue showing strong growth in mobile revenue as well as users. Recently the stock has made a series of higher lows, and revenues are growing. Therefore I would rather be long than short here, but think that owning cheap insurance in terms of this put spread is not a bad idea for someone who wants to smooth out the volatility of their portfolio.

Morning Update: Dow Theory

Dow Theory, developed by Charles H. Dow himself in the late 1800s, holds that the strength of a rally can be determined by the relative strength of stock indices. The theory holds that the Dow Transports should lead a rally in the Dow Industrials, since an improving manufacturing sector would require addition shipping volume, whether via boat, train, or air. Over 100 years later this is still a valid theory and is closely followed by many traders. Last week we saw the Dow Transports and the Dow Industrials close at new 52-weeks high, which has one option trader concluding that this rally will continue.

One of the top weightings in the Dow Transportation Index is Union Pacific, and this morning someone bought 100 August 160 calls for $2.95 with the stock at 152.83. This is $29,500 bet that UNP will be above 162.50, 6.3% higher, by August expiration.

The rally in the transports has been driven primarily by rails. The reason is two-fold. First, oil production in the Bakken is exceeding the current transportation capacity and driving demand for rail tankers up. The other reason is that crop production is slowing shifting west and away from rivers which have traditionally carried the bulk of crops to market. Union Pacific, along with Berkshire’s BNSF, are the two major players in the western plains and have the most to gain from demand continuing to grow.

This has been one of the most hated rallies in memory and investors who are having a hard time buying into this market at all-time highs should consider buying calls like this trader did. Downside risk is limited to the premium paid, which is only 1.8% in this case because of the low volatility in the market, and the upside is unlimited should the market continue its march higher.

Playing Netflix Earnings by the Numbers

Today after the close all eyes will be on Netflix, which will report second quarter earnings. The stock is up over 5% today ahead of the announcement, and option traders are betting that the stock trades higher after the release. The biggest trade of the day has been the purchase of 422 180 calls expiring this Friday for an average price of $9.08. This is a bullish bet that has a breakeven of 189.08 at the close this Friday.

The key to trading earnings announcements with options is to understand the implied volatility you are buying or selling. A quick way is to look at the nearest expiring at the money straddle. A straddle is an option spread that is long both a call and put at the same strike and same expiration. Right now the 170 straddle expiring on Friday is trading $26, which means traders are expecting that the stock will be within 15% of 170 at expiration. Most of this move is likely to occur tomorrow, so we can look at Netflix’s historical moves after earnings in order to decide if this volatility is cheap or expensive. In this case it looks to be on the cheap side: the historical average earnings move is 20.5% and the median is 18.0%.

From this it appears that buying options, as opposed to selling them, has the higher probability of success. This trader had the same view on the stock’s volatility, and took the trade a step further by taking a view on the stock’s direction. Instead of buying the straddle, which is a direction neutral strategy, they bought only the calls, suggesting they believe that the stock is likely to gap up more than the market is expecting. In the past Netflix has reported upside surprises 73% of the time, so this has also been the winning trade, historically.

Morning Update

One stock under performing the broad market this morning is Boeing. This has enticed one option trader to buy calls on the stock. The trade was the purchase of 294 August 85 calls for $5.25 with the stock at 87.00. This is a bullish bet that the stock will be above 90.25, or 3.7% higher, by August expiration.

Trades like this are a good example of how you can replace a long stock position with a call option. Investors who are uncomfortable with the market volatility this week can sell stock and buy 1 in the money call for every 100 shares sold. The result of this trade is a position that will profit if the stock continues to rally this summer, but will have limited losses should the market sell-off. The cost of this protection is that the stock must overcome the extrinsic value of the calls, also known as their time premium. In this case, a stock position bought at $87 would have a break even at $87, whereas the call position has a break even of $90.25, 3.5% higher.

However, a look at Boeing's fundamentals suggests that it may be a good stock to bet on this summer. Investors have been wary of the stock since mechanical problems caused the Dreamliner to be grounded. But soon US regulators are expected to end the grounding and allow the Dreamliner to return to service for the first time since January. Boeing’s customers know that that the early production run for a new product like the Dreamliner is likely to have glitches, and that these get sorted out in the first few months. That is the process Boeing is completing now, and it is unlikely to affect the future earnings power of the Dreamliner, which is expected to generate positive cash flow next year and continue to for years to come. Wells Fargo estimates that the Dreamliner will cause Boeing’s free cash flow to double next year to $12, or 14% of Boeing’s share price. This makes a dividend increase likely next year, and Boeing’s shares a good buy at current levels.

Buying a call now on Boeing will ensure that you do not miss a run-up in the stock over the summer, but does not subject you to all of the downside the shares could see if the market sells off hard, as it has this week.