Alexander Valtsev
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Why Harley-Davidson Is Still Expensive

No, I am not talking about the actual motorcycle, nor am I talking about the stock. In this article, I am talking about Harley-Davidson's (HOG) options. Almost two weeks ago, I said that the buyout rumor was likely a pump-and-dump instruments and the alleged deal with KKR would unlikely go through. My key argument was the unusual options activity around the stock's short-term options.

Well, the options are still too expensive, according to historical data from optionstrategist.com:

(Source: optionstrategist.com)

One of our fellow contributors recently wrote a great article about analyzing and trading on implied volatility. You can read the article here.

In short, Harley-Davidson's short-term options are currently overpriced as their implied volatility ranks in the 98th percentile in the sample gathered over the last 600 trading days. If you ask me, this is significant!

One of the best strategies to capitalize on overvalued implied volatility is trading calendar spreads (buying and selling two options of the same type for the same strike price but with different expiration dates). This is how it looks like in reality:

(Source: optionsprofitcalculator.com)

The idea behind this trade is that we believe the nearest-expiration (in this case, the August one) options are overvalued due to abnormally high implied volatility. Hence, we sell those. However, in order to do away with directional risk, we buy a longer-term option with the same strike price (there is little difference between choosing puts or calls - however, I am more inclined toward the idea that the stock will likely revert back to its pre-rumor price levels). The risk-reward profile looks as follows:

(Source: optionsprofitcalculator.com)

This is a six-week trade. A lot of things can happen to the company and the stock over the trade's duration. This is why the "window of safety" (the difference between the breakeven points divided by the current price of the stock) is so significant and represents over 20% of the current market price of Harley-Davidson's shares. The risk-reward ratio is particularly high: around 1.4:1. Of course, I have seen better ratios with other trades. However, there are two things that I like about this trade the most and that make it worthy of my consideration:

(1) The short-term options are clearly overpriced, as data on implied volatility show

(2) The margin of safety is very high. This is the #1 reason the risk-reward ratio is not that attractive

Investors make the most profit on this trade if the stock ends up being at the same level as it is now (i.e. the status quo is preferred). The trade becomes unprofitable, if the stock moves around 11% in either direction and stays in that region through the options' expiration. Remember that options involve high levels of risk and always do your calculations prior to making a trade.