Caveat Emptor

Gordon Scott |

Since the war of 1812, or at least at the day of its ending, when Mr. Organ bought large quantities of tobacco from Laidlaw & Co. and stood to make a killing on the resale, the American legal system has placed a responsibility on the part of the buyer to be the better informed party.

Mr. Organ knew that the trade embargo with Britain had been lifted and American tobacco would soon see increased demand. His suppliers, Laidlaw & Co., did not know this, although in the ensuing lawsuit the courts ruled that the information was publicly available and could have been learned by Laidlaw & Co.

In doing so the law supports the right for someone to simply profit from publicly available information if they can do so without creating deceptive communication. This legal opinion is considered the first to seriously institute the notion of Caveat Emptor, or in English, let the buyer beware.

In the current war on currencies (as some may call it), you have a legal right to profit from beaten-down financial stocks, assuming you can properly surmise what the publicly available information is telling you. One particular source of publicly available information that remains clouded by complexity is the pricing of options. Properly understood, options prices can give you an enlightening picture of what traders, investors, and market makers believe are the possible outcomes for a given stock.

The Case of a Bankruptcy Foretold

Using a measure called implied volatility, you can read what the market expects to happen in a stock’s near future.  Consider, for example, the case of Lehman Brothers stock and the prices of its options in March of 2008.  Two days before Lehman Brothers (LEH) reported earnings, on March 13th, the implied volatility for April options on LEH was around 85%. But the very next day, Friday March 14th, the day before the earnings report, the implied volatility for April options exploded to 188%.

Date LEH closing stock price Implied Volatility of April options
3/13/08 45.99 85.51%
3/14/08 39.26 188.92%
3/17/08 31.75 259.67%

Implied volatility scores can be read this as if they answer this question, “At what rate do you expect the price of this stock to change over the next 12 months?”  An implied volatility score of 50% means that market participants expect the stock to be cut in half or to rise by 50% sometime over the course of the coming year.

The score of 100% implies the possibility that the stock will double or go bankrupt. LEH’s implied volatility score of 259% anticipated that the company was on pace to go bankrupt in less than six months.  Interestingly, LEH’s last day of public trading was precisely six months later.

The Future of Financials

Your legal and history lessons thus complete, consider the state of two major banks with their backs against the wall right now.  Bank of America (BAC) and Citigroup (C) were caught in the ferocious market whirlpool last week and saw share price drops of around 30% in four days.

The implied volatility scores for these stocks also exploded over the 100 mark for those four days, effectively pricing in the possibility that these companies could go bankrupt within the next 12 months. But interestingly enough, the market’s pause allowed the implied volatility of these stocks to deflate rather dramatically this week so far. Consider the implied volatility of the September options on these two stocks in the previous few days:

*Date C
closing share price
C
implied volatility for September
BAC
closing share price
BAC
implied volatility
for September
8/4/11  34.81 49.94% 8.83 60.38%
8/5/11 33.44 59.71% 8.17 90.59%
8/8/11 27.95 105.49% 6.51 161.48%
8/9/11 31.82 88.38% 7.60 120.61%
8/10/11 28.49 105.75% 6.77 139.68%
8/11/11 30.29 99.02% 7.25 123.14%
8/15/11 31.27 72.86% 7.76 97.90%
8/16/11 29.94 75.44% 7.40 94.63%
8/17/11 29.85 70.60% 7.46 85.00%

*source “thinkBack” utility on the thinkorswim/TD Ameritrade trading platform

From this publicly available information, we can see that investors have priced in the possibility for bankruptcy of both these companies, but one of them (BAC) more significantly than the other.

The flip side of the downside

Implied volatility levels are not predictors of the future but rather quantified expectations. They may be self-fulfilling prophecies merely because they imply what traders expect to happen and thus guide the decisions of these traders over the subsequent days and months.

But if a 100% change in price is expected in the next 12 months, there is nothing prohibiting that move from being in the opposite direction of zero. In other words, at the pace these stocks are moving, they could just as easily double in price over the next year.

Investors love to bargain shop and these two stocks appear to be bargains. But is either of them worth the risk of bankruptcy? Option prices suggest that Citibank has less risk of bankruptcy. Investors and traders hunting for bargains may find it prudent to wait until an uptrend emerges on C. Regarding BAC, however, let the buyer beware!

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
BAC Bank of America Corporation 15.38 0.09 0.59 66,079,102
C Citigroup Inc. 46.87 0.50 1.08 15,871,608

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