Alexander Valtsev
1
All posts from Alexander Valtsev
Alexander Valtsev in Alexander Valtsev,

Smith & Wesson's Options Are Clearly Undervalued: Learn How To Profit From That!

Smith & Wesson's (SWHC) shares have had quite a roller-coaster over the last year:


In fact, this volatility can be expressed in historical standard deviation figures, which have been above-average compared to the broader market's data:

(Source: Google Finance. Calculations by author)

On the other hand, the short-term options on this stock are currently in the second quartile, based on readings from the last 600 trading days:

(Source: optionstrategist.com)

The straddle expiring in August is currently worth around 7.5% of the stock's market value which is substantially lower than the historical figures for the same duration (over 13% per month). Therefore, I recommend buying straddles expiring in August:

(Source: optionsprofitcalculator.com)

If you want to partially finance the cost of the straddles, you can sell a strangle (a one OTM call and a one OTM put), which will subsidize the cost but also limit your potential return. The straddles have the following risk-reward profile:

(Source: optionsprofitcalculator.com)

The "window of safety" is quite wide and exceeds 18% of the current market price. Of course, this is bad news for the investors because the stock must move swiftly in either direction in order for them to make money on the straddle. Otherwise, the options will become worthless, and investors will lose around $263 per contract. However, there are two reasons why options may become a lot more expensive than they are right now:

(1) The stock may move swiftly due to increasing talks about terrorist attacks all over the world (Paris, Orlando, Nice, etc.). This news typically sends the stock higher due to expectations of above-average sales of firearms;

(2) Implied volatility (currently stands in the 38th percentile) is mean-reversible. It is logical to assume that the figure will start climbing to the mean value, the 50th percentile. This will increase the time value of the options, thus making the straddle more valuable. We can also see that there is a clear and significant mispricing based on the historical data.

Investors have to realize that time decay is brutal for ATM options, so the straddle will quickly lose value, unless the stock and/or the implied volatility move swiftly. In my opinion, the five-week period is more than enough for the stock to move substantially in either direction. As a result, I believe that buying SWHC's short-term straddles now is a good time.