OPTIONS TRADING open book on table by One Photo via Shutterstock
Stifel Financial analysts downgraded Zoetis (ZTS) stock from a Buy to a Hold rating on Wednesday, citing slower growth over the next two years due to increased competition.
The animal health company’s shares fell by 4% on the news. Down nearly 8% over the past year, considerably worse than the 9.3% gain for the S&P 500 and 4.8% for Idexx Laboratories (IDXX), its biggest competitor.
As a result of the downgrade, its share volume yesterday was 4.66 million, x times its 30-day average. At the same time, the options volume was also unusually high, at 5,028, almost five times the average.
There were 2,014 unusually active options yesterday–1,001 calls and 1,013 puts. Of the puts, Zoetis had one unusually active option.
It signals a potential long straddle strategy for investors. The question is whether it’s the best strategy to use in this instance.
Here are my thoughts.
The July 18 $155 put above had a volume of 1,011 yesterday. There were a lot of bets made on the unusually active option.
The most significant trade among the 1,011 contracts was 44, which changed hands at approximately 9:42 a.m. I count 36 trades of 10 or more, and 66 trades of less than 10, indicating that this was a combination of retail and institutional investor bets.
As I said, the $155 strike set up for a possible long straddle strategy. There are pros and cons to this play.
The long straddle strategy is applied when you expect the volatility of a stock to increase and the share price to move aggressively in either direction, but are unsure which way it will move.
To execute the long straddle, you buy a call and put at the same strike price and expiration date.
This bet generates a profit if the share price at expiration (July 18) is above $165.40 or below $144.60. However, should it fail to move up 6.7% or down 6.7% over the next 30 days, you are out the net debit of $10.40 [$5.70 ask price on call + $4.70 ask price on put] or 6.71% of yesterday’s $155.06 closing share price.
When considering these strategies, it’s easy to think that a 6.7% move in either direction over 30 days is a realistic expectation. It’s not. The expected move over the next 30 days is 5.22% in either direction.
To increase your chances of profiting from this long straddle bet, you’d be better off extending the DTE by 28 days to Aug. 15, nine days after Zoetis announces its Q2 2025 results.
However, that would have cost you approximately $17.50 [$9.60 ask price on call + $9.90 ask price on put], or 11.5% of its share price, nearly double the July 18 call and put.
Interestingly, despite the lower expected move for the July DTE, the long call and long put pages suggest, at least individually, they have a slightly better profit probability, 1.92 percentage points higher [33.41% profit probability for July 18 $155 put compared to 31.49% for the Aug. 15 $155].
So, even though the July put has a lower expected move, the cost (net debit) of the long straddle, at $710, is less than that of the August put, making it more sensible.
But is the long straddle the best strategy?
Zoetis was spun off from Pfizer (PFE)in 2013.
Conducted in two parts, it first sold 20% of the animal health company in a February 2013 initial public offering (IPO). The remaining 80% was spun off in a share exchange on June 20, 2013, in which Pfizer shareholders received 0.9898 shares of Zoetis for each Pfizer share.
If you had kept your Pfizer shares rather than exchanging them for 0.9898 shares of Zoetis, your Pfizer stock would have lost ground over the next 12 years, generating an annual return of only 2.96%, because of the dividends.
Meanwhile, adjusted for dividends, 0.9898 shares of Zoetis would have appreciated by 15.5% annually over the same 12 years.
That’s the good news. The bad news is that most of the gains came between 2016 and 2021. Since its all-time high of $249.27 on Dec. 30, 2021, its shares have lost 38% of their value.
The likelihood of its shares moving higher seems remote given the downgrade. However, it wouldn’t be surprising to see it trading below $150 before too long.
So, the short bet is a better play.
Three possibilities to use based on a bearish outlook are the long put, bear put spread, or bear call spread.
Buying the July 18 $155 long put based on the numbers above, you’re making money if it falls below $150.30. Simple enough.
With the bear put spread, you’re buying a put and selling a put at a lower strike with the same expiration date. This bet limits your profit and loss.
Going long with the $155 put, here are three lower strike prices to consider. Given the difference in maximum loss between the $140 short put and $150 short put is only $170, or 1.1% of yesterday’s closing price, the $140 short put seems like the play with a risk/reward of just 0.38 to 1.
The final of three bearish put strategies is the bear call spread. Here you’re using calls rather than puts. It involves selling a call and buying a call at a higher strike price with the same expiration.
In this instance, using the same $155 strike but for calls, you’re generating a net credit rather than a net debit. For example, the net credit of the $155 long call and $165 short call is $3.10 [$4.60 bid price – $1.50 ask price]. The $170 short call raises the net credit to $4.00, and the $175, to $4.30.
If you’re bearish, despite the higher risk/reward, the profit probability is significantly higher than the bear put spread, varying between 60.3% and 64.1%, nearly double.
Counterintuitively, even though you’re exposing yourself to higher losses, you’re doing so to secure a profitable trade.
For this reason, the downgrade from yesterday likely led to some call action on the $155 strike. I see 22 calls in Wednesday trading. Not as much as one might expect.
In Thursday morning options trading, of the July 18 options, there is only one call strike that has had a trade of 10 or more [$160], with plenty of 10+ trades for put strikes, especially the $155.
Investors have spoken. The bear put spread is the play for those bearish on Zoetis.
On the date of publication, Will Ashworth did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. This article was originally published on Barchart.com
