Hello everybody. Welcome back to my blog. Today, I have another market idea that I want to share with you. It involves the company Equifax which currently experiences very busy and intense time. I would like to explore whether we can use this situation and sell some options.
The “Equifax” case offer a great opportunity to learn something new. It does not matter whether you are an investor, trader, option seller or complete novice to the financial world.
First things first – Brief introduction of Equifax
Equifax is an American company,active in the services sector. Its products and services are based on databases of consumer and business information derived from various sources. The company analyzes all available data over 800 million individual consumers and sells them as businesses credit reports or other analytics to interested parties. Such as insurance companies who use the data to asses people when they apply for an insurance policy. Other type of Equifax’s customers are financial institutions interested in Equifax’s credit reports and payment history of individuals. They want to know whether people are paying bills or repaying a loan.
Equifax is part of the Standard & Poor’s (S&P) 500 Index listing the largest U.S. companies. It is listed under the symbol “EFX”. The company market capitalization is still more than $11 billion, despite the decline in the price of its shares. Looking at the company financial summary, Equifax was doing pretty good. Steady growth over time as there was higher revenue and profit each year. Also the last quarterly report, published this summer, is positive.
I hope that this small research is not too exhausting. It had one main aim. To find out whether Equifax is a struggling penny stock or a large company with a steady growth. It seems that Equifax is rather a well-established company and I am satisfied with this result.
Why might Equifax be interesting for option sellers – data hack
Equifax was hacked as the company announced in the first half of September. The hackers have stolen millions of consumers data. This is quite a disaster comparable to the Volkswagen scandal with emissions software or with the British Petrol spillage of oil. As the news report, allegedly Equifax could prevent this cyber attack if exercising due diligence. The company did not really handle the matter well. They also reported the cyber attack after months since they have learned about it and so on. The price of Equifax shares dropped from $142 to $92. A drop of about -35% within a week. The panic sell-out is definitely not very good for Equifax investors, but option sellers might pay a bit closer attention.
To explain why this situation can be extremely interesting for an option seller, we have to explore what the implied volatility is.
Key point – implied volatility – measurement of panic
I always say that option is something like an insurance. To know whether the option price (price of the insurance) is relatively high, one has to look at implied volatility.
Now what is the implied volatility? No worries, I will keep it simple. For sure, I could write here a very theoretical and complicated definition, but I have a better solution, from the practice.
Implied volatility measures the demand for options (insurances). The higher the demand for options is, the higher is the price of options. But why is the demand for options suddenly high? Very simple, because people fear something and want to buy an insurance – the option. One can say that the implied volatility measures panic. It shows us exactly how big the demand for options is and how much it increased.
Let’s illustrate for better understanding
Imagine, you own a house and its value is $100.000. In normal circumstances, you can buy an insurance for $1.000 covering the whole value of the house. Many people still do not buy the insurance for different reasons.
Suddenly, there comes a hurricane. Nobody noticed, there was no warning, the hurricane is sweeping across the city and approaching your street. In our case, there is still the possibility to buy an insurance. However, everybody wants it now and the price has changed. The insurance suddenly cost $20.000, it will cover only half of the house’s value and there is one more condition. The first $50.000 must be covered by the house owner. Only if the damage is bigger than the first $50.000, the insurance will start covering the remaining $50.000.
Who is in better situation in your opinion? The insurance seller or the insurance buyer?
Before answering this, let’s consider one last thing. The insurance seller can very well decide which house to insure. He can make some research which houses have been built really well and have strong structure or which houses will not be affected by the strongest part of the hurricane.
The price for the insurance will not stay so high for very long. At one point, everybody who wanted to buy an insurance bought it. The demand for insurances decreases fast and so the implied volatility. After the implied volatility sky-rocketed, it will return back again. Consequently, the extremely high price of options will decrease as well.
Coming back to Equifax
When the company Equifax acknowledged that their data have been stolen, it triggered a huge sell-out of their shares. When the stock price fell -14% the first day, it caused fear and panic among everybody who holds the shares. The following days, the sell-out continued. Hence, everybody wants to have an insurance against falling prices. This function fulfills a put option.
As a result, the price of Equifax options exploded. The implied volatility is so high as never before.
Usually, implied volatility increase before quarterly reports, when companies publish their earnings. However, the current increase of volatility is not comparable with any increase before earnings. It is as if you compare a hill behind the village with Mount Everest.
That is why I am going to sell put options on Equifax.
Selling put options
Thanks to the huge implied volatility, it is currently possible to sell put options very far out-of-the money while still getting a nice option premium. This means that even when Equifax shares currently cost $93, I can sell a put option betting that the price will not go below $60. Usually with the stock of the same value ($93), one could sell a put option with the strike price of about $87 to receive the same option premium. This shows how huge impact the option implied volatility has.
To be concrete, I consider two possibilities:
- Selling put option with the strike price 70, expiration date on 20 October 2017 for the option premium of $120 per option. This option is valid 32 days.
- Selling put option with the strike price 60, expiration date on 19 January 2018 for the option premium of $190 per option. This option is valid 123 days.
In normal circumstances, I sell stock options with about 40 days left to expiration. The reason is that I do not want to hold the option when the company will publish its earnings. However, I decided for the second choice with 123 days till expiration because I want to profit from the volatility decrease.
I will also follow the October option expiring in 32 days. Then, I will tell you whether a made a good choice.
Safety cushion or a high risk?
Some people will say that Equifax fell once -35%, why shouldn’t it fall another -35%? And they might be right. There are however other things to consider.
From my experience, I know that people tend to overreact at the financial markets. The stock has been declining with a raising volume. The highest volume occurred on 14 September 2017. Since then, the volume declines. That indicates that everybody who absolutely wanted to sell the stock already sold it. I expect that the situation will calm down.
Sure, the value of the company can decline below $60 per share. The theoretical worst-case scenario would be a bankruptcy. However, company does not go bankrupt from one day to another. Especially not companies that have experienced steady growth in the last years. Many people were completely surprised by this situation, even the big boys with a lot of money. They do not want big losses, even if they would need to artificially push the price up. In addition, Equifax can buy this year about $600 million worth of their own stock. This might stabilize the situation.
Use the advantages of option selling
The option sellers are not only affected by the development of the stock. The implied volatility decrease will cause a decrease in price of Equifax options. It might happen very fast. Plus, time works for us as option sellers. Everyday, the option losses part of its value because of time decay.
There are risks everywhere in life. One has to assess the probability that something might happen. The sold option on Equifax has 10% probability to end up in-the-money. In other words, there is 90% probability that it will stay above $60 per share. I think I can live with these odds 🙂
I will provide you an update how this trade ended up. In the meanwhile, check out my other option selling trades.
And don’t forget to let me know, what do you think about this market idea.