Markets were down in Thursday trading, with the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite off 1.32%, 0.87%, and 1.0%, respectively. Moderna (MRNA), retail stocks, and the Mag 7 all took it on the chin yesterday as oil prices climbed, as did the 30-year Treasury yield.
As I write this Friday before the markets open, the futures are up as investors await data from the PMI (Purchasing Managers’ Index) survey. The preliminary August number is expected to be 54.0, which indicates the economy is expanding.
Thursday’s options volume was 60.4 million, down significantly from the 90-day average of 64.0 million. While 55% of the volume was calls, they didn’t outnumber puts nearly as much as they have on other days in August. It’s a sign that investors are getting more timid about their bets.
Pacific Gas & Electric (PCG) led Thursday’s unusual options activity with an Oct. 16 $25 call that had a Vol/OI (volume-to-open-interest) ratio of 176.44, slightly ahead of Blue Owl Capital’s (OWL) Nov. 20 $11 put at 161.95. They were the only options with a Vol/OI ratio over 100.
While it would be fun to cover the beleaguered private credit asset manager, whose stock is down nearly 40% over the past year and barely above where it began to trade in May 2021, I’m going to go with California’s largest utility because it had a second call that also had a high Vol/OI ratio that was in the top 100 on the day.
Have an excellent weekend.
The PCG Call Options in Question
Without looking at yesterday's options flow, the two things that stand out from the two calls are that they both expire on Oct. 16 and both experienced a considerable increase in volume. Further, they accounted for 35% of the 128,882 contracts traded, which was 1.3 times the 30-day average of 97,901. In addition, the P/C volume ratio was 0.20, which is very bullish.
Looking at the options flow below, the two largest trades by volume were the Oct. 16 $20 call and $25 call at 20,000 each. They both took place at 10:48 a.m. ET. They were both new positions in a crossed, multi-leg trade.
The Options Strategy in Play: Bull Call Spread
A Bull Call Spread is a bullish bet on PCG that involves buying one call and selling another call at a higher strike price to generate premium income that offsets some of the cost of the long call. Here’s how the trade looked at the end of yesterday’s trading.
Based on the 20,000-contract trade from yesterday, the $0.72 trade price for the long $20 call leans toward the $0.75 ask price, while the $0.12 trade price for the short $25 call leans toward the $0.10 bid price, which helps confirm the bull call spread.
The net debit, which is also the maximum loss for the trade, is $60 per contract [$0.72 trade price - $0.12 trade price and premium offsetting the long call cost], or a reasonable 3.3% of the share price at the time of the trade.
The maximum profit for one contract is $440 [$25 strike price - $20 strike price - $0.60 net debit * 100]. The maximum profit percentage is 733.33% [$440 maximum profit / $60 maximum loss]. The maximum profit for the entire 20,000 contracts is $8.8 million, while the maximum loss is $1.2 million, a risk/reward ratio of 0.14 to 1, which means for every dollar in potential gains, your defined risk is 14 cents.
As you can see, the end-of-day example suggests there was a 23.1% chance the share price at expiration would be above the $20.61 breakeven [$20 lower strike price + $0.61 net debit]. That’s a 14.76% move over 57 days. The expected move over this period is 11.65%. It’s doable but unlikely.
The 20,000-contract trade would have similar numbers because the maximum profit and maximum loss were only one cent higher.
Why Did An Institution Make This Play?
Newer options investors would look at this bet and focus on the one-in-four chance of making money on the trade. An institution would consider the favorable payoff and how that skews the probability.
For example, without getting into the math, if you flip a coin 10 times, the probability of getting more heads than tails is 37.7%. That’s completely random, yet it’s not far off the bull call spread’s probability of making money, and several things could influence PCG’s share price in the future.
In the case of PG&E, it reports earnings on Oct. 22, after the bull call spread’s expiration on Oct. 17. That suggests that the bet is based on something happening between now and October 17.
On Aug. 18, UBS reiterated its Buy rating on PCG, with a $22 price target. The analyst specifically cited comments from California Governor Gavin Newsom about wildfire liability reform. If positive reform occurs, that could significantly improve the utility’s business in the state. If it doesn’t, it’s likely to reduce its California growth capital expenditures and reallocate free cash flow to higher dividends.
Either way, the institution has made a low-risk, high-reward bet that a catalyst to move the stock higher could appear before the end of August, or possibly, in September.
Yesterday’s 20,000-contract bull call spread is a textbook defined-risk bet.
On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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