Watson is king once more. After meeting with resistance in the $210-$212 area multiple times in the past year, IBM’s stock convincingly broke that level this morning to make a new all-time high. IBM has been on an incredible 20 year run, from around $10 in 1993 to $215 today, a steady, nimble business behemoth in a time of rapid change.
Zooming in, here is the 3 year daily chart:
There is a lot going on in this chart, but it’s important to my thoughts and trade, so I wanted to include it all on one chart. I’ve marked the first red line at the 130-135 area in IBM, which acted as resistance in 2008, 2009, and 2010, before finally breaking in late 2010 (the first green circle). Once it finally broke out, it rallied 10% in a month before it finally paused, not a surprising event when long-term resistance is finally broken.
I’ve highlighted in green the other instances where IBM’s stock broke out on an overbought RSI (when RSI gets above 70 in the lower panel). 4 of the 5 situations led to continued runs higher, while the Apr 2011 instance was rejected.
Why am I so focused on the technicals of IBM? This is where using options gets interesting…
When stocks make new breakouts like this, options oftentimes get bid up as traders prefer to own options to play for a fast move on the breakout rather than buy stock and risk a false breakout scenario. In that sense, IBM’s breakout to new all-time highs presents a likely either/or scenario. EITHER IBM’s breakout holds and the stock continues its march higher like the previous instances in the past 3 years. OR IBM’s breakout today is a false breakout, and IBM breaks back below the prior 212 resistance level, faking out all the new buyers who bought the breakout today.
In either case, this type of setup is conducive to a fast move in either direction. It’s rare that IBM’s stock just sits right above the breakout level. So are option prices expensive as a result?
Here is the 1 year chart of 30 day Implied Volatility (red) vs. 30 day Realized Volatility (blue):[caption id="attachment_23672" align="alignnone" width="681"] 1 year chart of 30 day IV vs. 30 day RV, Courtesy of LiveVolPro[/caption]
As expected, the IV collapsed after earnings in Jan, and has inched higher ever since. While realized volatility is still near the lows of the last year, around 13, my anticipation is that realized volatility will pick up as a result of the breakout in IBM’s stock (the Either/Or scenario above). However, if I’m wrong, and IBM sits here for the next few weeks, I don’t expect implied volatility to get crushed in April options because IBM is slated to report on Apr 16th, prior to Apr expiry. As a result, those option prices are likely to remain supported by the expected earnings event.
I haven’t touched on IBM’s fundamentals because I don’t have a strong view. The historical P/E looks fair:[caption id="attachment_23673" align="alignnone" width="501"] 7 year chart of trailing P/E for IBM, Courtesy of Bloomberg[/caption]
Analyst earnings growth projections are for 10% per year for the next 3 years, a light deceleration from the 15% growth rate of the past 3 years, but no drastic change. Paying 14x for a 10% grower (if consensus comes true) seems fair to me. What seems more important at this juncture is the psychology of the breakout to all-time highs. Hence the focus on the technicals.
So here’s the trade:
TRADE: Bought the IBM ($214.42) Apr 215 Straddle for $8.90
-Bought 1 Apr 215 call for 4.15
-Bought 1 Apr 215 put for 4.75
Break-Even on April Expiration:
-Profits below 206.10 and above 223.90, with no cap on profits
-Losses of up to 8.90 between 206.10 and 223.90, with max loss of 8.90 at 215
I don’t have a directional bias on IBM. So I chose a delta neutral trade. Rather, this trade is based on my view that the Either/Or scenario of continued appreciation after a breakout or a quick selloff after this false breakout are the two likely scenarios. If I’m wrong and the stock does not move much in the next few weeks, then I still think I can exit the trade prior to earnings for a 2-3 dollar loss in the worst case scenario. As a result, I like the asymmetric risk/reward of a structure like this with IBM breaking such a pivotal level today.