Speculation Strategy
In the scenario of a binary outcome, as is the case with Under Armour (Ticker: UAA), it would be smart to hedge your bets in case your prediction turns out to be wrong. Because of this I recommend a Protective Put strategy (See Figure 1). The call option provides virtually unlimited upside potential if the investigation turns nothing up. The put option will counteract gains provided by small stock movements but more importantly it will protect you from losing all of your money if the investigation does turn something up.
Theoretical Prices
Using the Black-Scholes model to value options the following options prices were calculated using an annual interest rate of 1%.
January 15, 2021, call @ 30 strike
Calculated Price=0.58
Actual=0.64
January 15, 2021, put @ 10 strike
Calculated Price=8.48
Actual=0.42
From the data above we can see the prices for the call option are very close. The put option however is calculated to be much more expensive than the actual trading price of the option. This difference can be attributed to the beliefs the investors have. Despite the news of an investigation and the price of the stock dropping more than 10%, That put option’s price didn’t go up which means investors don’t think it is likely that the investigation will turn anything up so its equally unlikely the stock price will drop to the strike price of $10.
Historical and Implied Volatility
Using historical close data from the period of November 1, 2018 to November 1, 2019, UAA provides an annual standard deviation of 0.39. While historical volatility can be useful to help us understand the patterns of a stock it isn’t always useful for shorter term analysis as the effect of big movements will get watered down by the historical average. We don’t care about past volatility as much as we care about the current implications of the volatility. Implied volatility measures the current volatility of the whole market
To find implied volatility, using the Black-Scholes model I took the average of calculated sigma for four different strike prices on call options and got sigma=0.41. This means options of UAA have a current volatility similar to its historical average.
Due Diligence
In regards to the investigation itself, corporations are often smarter than the government, they thrive in operating in grey areas. With the way the U.S. justice system operates there is a good chance UAA pays a small settlement and doesn’t even have to admit guilt. Which might subdue the effect this investigation has on share prices of UAA.
If you are holding options in UAA the question more important than will they be found guilty or not is, by your expiration date (January 2021) will the companies stock price fall or go up? Because that is what ultimately determines whether you win or lose money on your options. It is true that if they are found guilty their stock price will get hurt but having more than a year until the option’s expiration there is still a chance the stock price rebounds based on other forces. For example, Morningstar reports UAA will benefit from a partnership with Kohl’s and its restructuring will produce an average annual savings of $200 million over the next five years. Both of the forces I have talked about in this section play into the hands of the UAA bulls.
Binary Outcomes
If you follow my advice and use a protective put strategy the following would be your returns in the listed binary outcome if you bought a call option with an expiration of January 15, 2021 at strike price $30 and a put option with the same expiration with a strike price of $12.50. Your overall options strategy would cost $162 for one contract of each.
If UAA rises to $30/share, the price of your call option would rise to $5.43. Your initial investment would rise from $162 to $534 based on your call and your put would lose all of its equity so $534 would be reduced to $436. This movement would bring you a rate of return of 169%.The nominal amount of money you make would only increase if you choose to buy more than just one of each contract.
If UAA falls to $10/share, the price of your call option would basically be $0 but your put option would appreciate 2.44%. This means you would end with $100 of total equity, which would be a rate of return of -38% as opposed to -100% if you only bought a call option.
Recommendation
I recommend taking a bullish stance on UAA as they will likely not have to pay a lot and will not have to admit guilt. Also the upside of a protective put strategy is far beyond the loss you might take if UAA’s stock price falls to $10. Even if that is the case UAA has other positive attributes that may enable it to make a comeback even if its stock price does fall by that big of a margin.