A recent article posted on Bloomberg reported that two Goldman Sachs (GS) analysts suggest buying McDonald’s (MCD) June 70 Calls (MCD 100619C00070000).
They make a strong case for buying these calls based on several factors:
Their first argument is that MCD implied volatility for June is near its all-time low of 15.06. The two analysts also believe that McDonald’s will report strong earnings, and that the new McSmoothie will help McDonald’s sales outperform estimates for May.
At first glance this appears to be a smart play using options, and while it is extremely bold of me to bet against Goldman Sachs, I would argue that there are several factors traders should think about before entering the trade. In addition, there may be other option trades that present similar rewards with less risk than the bet Goldman Sachs presents.
For starters, I take issue with their argument that the June 70 calls are a good buy based on the fact that June implied volatility (IV) is near an all-time low.
One of the major problems with trading a “recommended” option is that as soon as an option becomes “recommended” by a firm such as Goldman Sachs, much of the advantage of the trade is almost immediately sucked out. Why?
Because traders follow this advice, and this creates visible demand. When demand for an option is created in one direction, the implied volatility moves. Thus, if there was any alignment problem with the June 70s, that alignment is now gone, taken care of by the more than 3,000 contracts that traded on the June 70 calls shortly after Bloomberg reported the story. This is one of the great things about having sway; predictions become self-fulfilling prophecies.
Another common mistake is the belief that implied volatility going up will make the trader money. This is not necessarily true. In many cases, especially earnings, the perceived increase in volatility is not due to an increase in value of the options. It is caused by the options failing to decay as quickly as the trader’s theoretical model predicts.
Take the suggested MCD calls, for instance. These options have a theta decay of 1 cent a day. At the close of business on April 7, the calls marked at a value of around 85 cents and implied volatility of 15.65%.
If the stock stays stable leading into earnings, scheduled for April 21, the model predicts that the calls should be worth around 71 cents. If the calls are worth 80 cents on April 21, the implied volatility of the options would be 16.65%. Implied volatility went up 1%, yet the trader has lost 5 cents a contract.
I also disagree with the suggested date of entry. I do not see how it is to the trader’s advantage to buy these calls now, especially after the option has been recommended. At this point, traders can probably wait and get a relatively better price in two weeks (when comparing the price of the options to the where the stock is trading).
A Better Option
My strongest argument, though, is that when evaluating a trade, the trader must look at two scenarios: being right and being wrong.
If a trader thinks that MCD is going to rally to $71, the June 70 calls may be a very good play. But what if MCD only rallies to $69, or drops to $66 by May 1 instead?
I believe the MCD June 67.50 Calls (MCD 100619C00067500) might be close to as good of a bullish play without nearly as much risk to the downside.
If MCD goes to $71 by May 1, I would expect implied volatilities to drop. Even with implied volatilities as low as they are now, MCD IV would likely drop at least 1%. This is something traders must consider when evaluating the trade.
On May 1, with the June IV down 1%, the June 70 calls would be worth $1.93, which is a great return of 127%. I do not think any trader would be disappointed with those results.
The 67.50 calls would be worth $3.77. If a trader bought those on the April 7 close for $1.93, I don’t think he or she would complain about the 95% return on investment either.
Now, if MCD only rallies to $69 and IV decreases by 1%, the June 70 calls would be worth 95 cents. No trader would complain about his or her 17% return, but that isn’t going to pay for a condo in Boca Raton either.
In this scenario, the 67.50 calls would be worth $2.30, a return of just over 19%. While this won’t knock anyone’s socks off either, the trader would fare better owning the 67.50 calls.
What if MCD disappoints and the stock closes at $66 on May 1?
In this scenario, I am actually going to raise implied volatility slightly by 1%. The 70 calls would be worth 34 cents under these conditions, a disappointing 60% loss of capital. The 67.50 calls would be worth $1.02, a 47% loss, so the trader is in better shape owning the 67.50 calls than the 70 calls. And if IV increases by more than 1% the trader is in even better shape.
While at first glance the Goldman Sachs recommended option seems like a smart choice, there are always other options that may present similar reward with less risk.
Traders should obviously take into account what experts are saying and suggesting, but more importantly, traders must do their own leg work. You should not enter an option trade simply because Goldman Sachs or another credible source suggests. After all, if those two Goldman Sachs analysts jumped in the lake, would you jump in after them?
Editor’s note: The source for the options evaluation was the thinkorswim theoretical price function.
Related Articles:
- 4 Casino Trades to Take a Gamble On
- The Easiest Way to Profit From Mispriced Options
- Your Golden Ticket to Dividends and Growth
The Options Trader’s Guide to Technical Analysis
In his latest report, learn how John Lansing leverages the power of technical analysis to identify the short window when a trade is set to go straight up or down. Get your FREE copy here!
