Shares of DraftKings (NASDAQ:DKNG) have been on a tear since the IPO in late April. DraftKings stock has more than doubled in that time frame. It has benefited from the stay at home orders as bettors no longer could head to the casinos.
Certainly some of the move higher was warranted given the uptick in platform use and the increased likelihood of more states legalizing gambling to bring in much needed revenues. The red-hot rally has now come too far, too fast. Time to cash in your bets on DKNG.
Matt McCall and the InvestorPlace Research Staff put together an outstanding research report yesterday. They highlighted many reasons to like DraftKings stock going forward, but wouldn’t be a buyer at current levels due to valuation concerns. Instead they recommend waiting for a pullback before buying DraftKings stock.
The average analyst price target is just $38.57, which is below the most recent closing price of $40.53. Susquehanna analyst Joseph Stauff did just up his price target recently to $48, while Cannacord Genuity analysts Michael Graham has a street high $50 price target. Both of these price targets imply limited upside from here for such a volatile stock like DKNG.
DraftKings stock has been overbought for a while but is finally starting to lose some steam. 14-day RSI has turned lower after reaching an extreme. MACD is also beginning to weaken. Momentum has finally pulled back somewhat after getting to seriously over-exuberant levels.
Most importantly, DKNG stock had a key reversal day after making a new all-time high of $44.79 on Tuesday. Shares opened near the highs but immediately began to pull back. Ultimately DraftKings stock closed sharply lower on the day.
This type of price action is many times a reliable signal that the previous trend has come to an end. The buyers have become exhausted and the sellers have taken control. It is even more powerful given the magnitude of the previous rally.
The options market can provide good insights into the speculative fever surrounding big time momentum stocks. Traders can glean some solid information looking at at the option volume broken down between calls and puts.
The table below shows the enormous appetite for call options with 3.4 calls trading for every put. This type of over-exuberance is usually a reliable contrarian indicator that the rally may be getting overextended.
Source: The thinkorswim® platform from TD Ameritrade
Normally out-of-the-money puts carry a higher implied volatility (IV) than similar out-of-the-money calls. A look at the Apple (NASDAQ:AAPL) option montage shows that the June $310 puts are trading at a 26 IV, while the June $340 calls are trading at just a 21.50 IV. Both options are roughly equidistantly (12.5 points) out of the money. This is typical for most stock options.
DKNG options, however, exhibit what is called a reverse skew. The calls carry a much higher IV than the similarly out of the money puts.
The June $35 puts are trading at a 92 IV while the June $46 calls are trading at over a 98 IV. Both options are roughly 5.5 points out of the money. This type of option pricing anomaly is rare and invariably a signal that the rush for upside exposure has reached an extreme.
The high level of comparative IV also sets up ideally for selling these expensive calls to structure a guardedly bearish trade. So to position for the red-hot rally to stall, a simple bear call spread makes probabilistic sense.
Sell the DKNG June $50/$55 call spread for a 50 cents net credit.
Maximum gain of the trade is $50 per spread with maximum risk of $450 per spread. Return on risk is 11.11%. The short $50 strike price provides a 23% upside cushion to the $40.53 closing price for DKNG stock. It is also above the upgraded $48 price target from Susquehanna and right at the highest price target of $50.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a weekly option and volatility newsletter can visit the Options and Volatility Newsletter website.