HOT SHOTS: EDS Takes Another Fall
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September 24, 2002
Last week, shares of Electronic Data Systems (EDS) were cut in half when the company warned about future earnings and revenues. After falling from $36.46 on September 18 to $17.20 on September 19, the stock then moved slightly lower the next two sessions. However, this changed on Tuesday when EDS took another major hit. The company was downgraded at Merrill Lynch from a “Hold” to a “Sell” and had its credit rating put on watch at Moody’s. This took the stock down another 30 percent to close at $11.68.
Tuesday’s decline fits into the five-minute success formula. The stock fell 30 percent on extremely strong volume, spiking implied volatility sharply. The skew between front-month and back-month options is massive. For example, the October 10 put has IV near 150, with the March 2003 10 Put IV at 96. However, even the backend IV is extremely high compared to historical values.
There are two ways to look at EDS and its options. One would be to place a calendar spread using puts that would take advantage of the fall in IV in the short-term. The other would be to use calls, paying down the price of a long-term option by selling the high-priced front-month options. Of course, the problem with the latter is that IV is high on the back month as well.
I normally like to use calls to take advantage of a possible bounce in the stock price. However, in the case of EDS, any bounce seems likely to be short-lived. With the overall market showing bearish tendencies, it may be hard for EDS to garner much strength. Even though the long-term options have high historic volatility, we can profit in the next few months by placing a calendar spread on the stock. Support may develop at $10, so this may be the best place to enter this strategy.
Since EDS is trading in the middle of two strike prices, we don’t have a true at-the-money strike to use. However, if EDS consolidates near $10, which is likely, we not only would benefit from the drop in front-month IV, but would also profit from a bearish move toward $10. Watch for a quick profit and get out of this one, as the stock could also move all over the place in the months to come.
Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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