For sometime, I have been holding on to Hewlett-Packard January 55 calls hoping that as the economy turns around and PC sales begin to pick up, HPQ would make its move towards that 55 strike (currently trading at $48.30). However, I decided to swipe out of my position in HPQ call contracts for Dell, despite the financial media just bashing on this company. Here is why:
After analyzing HPQ, IBM, DELL, and AAPL, I found some interesting results. Right off the bat, Apple does not amuse me. Allow me to take the contrarian approach on this one: AAPL is extremely overbought and to add, most analysts and individual investors are just TOO optimistic with Apple. The option contracts I was looking at were extremely over valued relative to its peers. Don’t get me wrong, Apple has great ‘innovative’ products, but they can only go for so long. What about Buffet’s ‘economic moat’ theory on this one? I still consider it, do others?
Ok, so now that Apple is gone, let us compare HPQ, IBM, and DELL. Looking at January calls that are roughly out of the money by 13%, 15%, and 12%, respectively, HPQ calls have the lowest premium demanded, followed by Dell, then IBM. With IBM also having the lowest probability of outperforming the S&P 500 index relative to HPQ and DELL not to mention the lowest 1 year volatility average (meaning the equity is less likely to move a lot thus leaving the option contracts less appealing), I will forget IBM.
Here we have it, HPQ or DELL? Personally, I have a Dell laptop and just love the computers, but that is beyond the point. DELL has a higher probability of outperforming the market by roughly 2%. The volatility is much higher than HPQ suggesting that Dell will more likely reach its strike faster than HPQ will. Year to Date, Dell has been outperforming HPQ by a near 2000 basis points. So with this all said, with the option contracts that are both out of the money by almost the same amount (considering intraday movements) with the same expiration, the premium for Dell is only $.07 more, or $7.00 per contract. I believe that is well worth it. By January, I look forward to discussing the movements both HPQ and Dell will have, going on the assumption that Dell will continue to outperform HPQ. Earlier this morning, Microsoft acknowledged strength in its Windows 7 product and PC demand is believed to have stabilized and expected to grow as businesses and people upgrade to newer computers. Of course there are other macro issues that could be figured into these assumptions but in the end, I believe Dell will flourish in terms of share price movement relative to Hewlett.
Thoughts and criticism are always appreciated.
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4 comments:
If your analysis is correct, it seems that the best move would be to buy call options for Dell and buy put options for HPQ. Doing so would take out the macro economic fluctuations in the market and Dell will just have to outperform HPQ in order to profit. Do you think this is the best play?
Even though Wall Street likes to clump together loosely comparable companies as being in the same industry it is worthwhile to note that the three companies that you mentioned; IBM, HPQ, and DELL, are not all in the same line of business. Dell sells personal computers along with a small business line. Hewlett Packard sells personal computers, but makes a larger portion of its income from its extensive line of servers and commercial computer and storage systems. IBM, on the other hand, does not sell any new personal computers, and makes their money selling mostly mainframes, software, and consulting services. That being said, IBM's performance should be completely independent of the release of Windows 7. The fact that these stocks trade together, and on news that does not equally, or at all affect them, is the result of investors not fully understanding the business models of these firms. Be careful which catalysts you apply to which firms, because sectors, subsectors, and other industry classifications can be very misleading.
It is a great point that you made to possibly buy puts on HPQ to eliminate macroeconomic fluctuations, however, the reason I am afraid to do so is because I do believe that the general tech sector still has room to rise. I feel that because DELL is more volatile than HPQ, which is one of several reasons why I did change my position, if HPQ puts were to eliminate any macro issues, what comes to mind rather than HPQ puts would be to ‘straddle’ DELL, or go long a put and call with the same strike and expiration. However, a more interesting thought derives from the issue, one which was brought to my attention by Steven Louis.
In his response to this post, he warned me to be careful because HPQ, DELL, IBM, and other tech companies are generally assumed to be comparable companies by the street when really the business models for the firms are significantly different. I understand that yet based on many resources, unfortunately, Dell is compared to other firms that are not 100% comparable and I wanted a decent sample size to compare volatility and such to firms in the same ‘sector.’ Moving forward, to offset any macroeconomic fluctuations that could hurt calls on DELL, Steven Louis suggested to buy protection in perhaps other sectors that are independent of the sector (or company) that is being long, in this case, DELL. This ties into his point that even though companies may be very different yet still fall within the same ‘sector,’ one company that is not so well (whether it is on a fundamental or technical basis) could weigh down companies that have the exact opposite characteristics. Figuring out which sectors to buy protection in to offset any loss incurred in another sector would be worthwhile to research. Perhaps for a start, finding sectors that have low correlations would be most appropriate. Otherwise, buying puts on a stock to offset calls on a stock, both stocks in the same sector, the correlation is most likely high. So if a bad stock sticks out like a sore thumb, the move could be right, otherwise, I would be careful. Besides that, if I owned 100 shares of the underlying stock in DELL, I would just simply buy an ‘at-the-money’ put.
Just want to clarify what I had suggested to H.W. Daniel in terms of sector diversification with downside protection. Firstly, I don't know that you would want to seek out sectors with particularly low correlations if you are to have one position long and the other short. The lower the correlation, the lower the probability that your short (put) position will make money if your long (call) position heads downward. The only way to ensure that your short position will appreciate if you long position suffers is to be long and short the same stock (or straddle it with options, but in that case you have to take into consideration the spread and time decay).
What I was suggesting is to first determine your bullishness on the market in aggregate as represented as a percentage. For instance, lets say right now I am 70% bullish on the next three months. I would then devise a portfolio consisting of 70% long positions and 30% short, be it buying calls and puts or buying or shorting the underlying common. The key point though, the one that H.W. Daniel is referring to, is that I believe that all positions, both long and short, should be diversified across sectors.
The idea being that just as long positions are chosen based an intrinsic value analysis resulting undervalued, so too should short positions be chosen based on overvalued determinations.
Please comment back with any questions or for any clarification, but the philosophy behind this proposed strategy is that risk can be decreased by tailoring the portfolio long/short ratio to market temperature, and increase profitability by choosing short positions to hedge long positions based on which stocks are the most overvalued and with downward catalysts.
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