When Buying Options IS a Buzzkill

Hey Traders,


The pot sector has been in focus this week, thanks to the “4/20 holiday” celebrated by weed smokers (*cough* or so I’m told *cough*).


In addition, the House of Representatives on Monday voted to approve the Secure and Fair Enforcement (SAFE) Banking Act, which essentially protects banks that do business with state-legal cannabis companies from federal prosecution.


Courtesy of ETFMG.com


The bill should allow many fledgling pot firms — several of which have been relegated to working with cash — to secure banking services, and is expected to pass a Democrat-controlled Senate.


Amid the Mary Jane brouhaha, we saw some unusual options activity on several marijuana stocks early in the week, even as the sector dipped …


And the action on one stock, in particular, caught my attention — and reminded me of a good lesson for all the penny-stock players out there …


So today, let’s hop in the ol’ Cheech & Chong lowrider for my take on weed stocks — and a quick coaching session on when NOT to buy options.


I’m Paranoid to Play Long-Term Pot Stocks


Ironically, the ETFMG Alternative Harvest ETF (Ticker: MJ) — a fund that basically takes the temperature of the cannabis sector — had its worst session in at least a month on 4/20, as evidenced by that ugly candle on the chart below.


The weed ETF was more recently seen testing a foothold atop the round-number $20 level, which acted as a floor earlier this year, as MJ retraced a February rally to $34.


Daily chart of MJ – courtesy of StockCharts  


This ETF tracks the Prime Alternative Harvest Index, and among its top holdings are weed notables GW Pharma (Ticker: GWPH), Aphria (Ticker: APHA), Tilray (Ticker: TLRY), Canopy Growth (Ticker: CGC), and Cronos Group (Ticker: CRON).


However, you may be interested to know that tobacco giants Philip Morris (Ticker: PM) and Altria (Ticker: MO) are also in MJ’s top 10 holdings.


In fact, per ETFMG.com, MJ has over $1.6 billion in assets, with 32 holdings — and “around 20% of its portfolio consists of tobacco stocks.”


Personally, I tend to steer clear of weed stocks — at least for longer-term plays — because if marijuana gets legalized across the board in the U.S., you can bet your bottom dollar the big tobacco boys will be looking to jump in and make some noise …


Something else I tend to avoid?


Buying options on “buck stocks.”


When Options Leverage Goes Up in Smoke


As alluded to earlier, I saw some notable options action in the pot sector earlier this week, but the security that caught my attention was Sundial Growers (Ticker: SNDL).


Not because it’s a phenomenal stock or anything …


Because the action in the option pit seemed … unnecessary, for lack of a better term.


That’s because SNDL spent most of the past year as a LITERAL penny stock, trading under $1. 


Daily chart of SNDL – courtesy of StockCharts


See, a stock that cheap inherently offers relatively minimal risk vs. reward, since the most the shares can lose is a dollar, and the most they can gain is theoretically unlimited.


Therefore, the LEVERAGE that long options typically provide is somewhat muted for these penny stocks. 


Think about it — buying options on a stock like, say, Amazon (Ticker: AMZN) makes perfect sense, considering the shares are trading above $3,300. 


So, to control 100 AMZN shares, one could pay about $330,000 … or buy one option contract for a fraction of that!


Obviously, AMZN options are the way to go.


But when we’re talking about something like SNDL, which is trading around a buck …


Well, why bother buying call options when you could buy the shares outright for so cheap?


After all, SNDL closed yesterday at a whopping 87 cents — so 100 shares would cost $87 … That’s less than what many pot smokers spend in a week  (*cough* I’d assume *cough*).


Yet, on Tuesday — 4/20 — SNDL added more than 77,000 1-strike call options expiring tomorrow, April 23


SNDL largest open interest changes April 14-21 — courtesy of Trade-Alert


The biggest block of those 1-strike calls was a batch of 8,700 contracts, which were bought for about a nickel apiece on Tuesday.


So, let’s say the SNDL bulls’ predictions came to fruition, and the shares skyrocketed to $1.50 before expiration tomorrow.


The trader who bought shares outright for 87 cents — their 100-share stake would now be worth $150, a healthy 72% return in less than a week.


Meanwhile, those 1-strike calls would have 50 cents in intrinsic value, which is the difference between the stock price and the in-the-money option strike.


If the call buyer closed their winning position for that much, they’d make a 45-cent profit (intrinsic value less the 5 cents paid for the option) — or a 900% gain. Which sounds enticing …


BUT NOW, let’s say SNDL continued to stagnate through the end of the week — a more likely scenario — finishing at 99 cents.


In this case, those very short-term 1-strike call options would be worthless, and the trader could very well lose the entire 5-cent premium — a 100% loss. 


The shareholder, on the other hand, would be up $12 on their $87 investment — about a 14% GAIN…


And, perhaps more importantly, they’re still positioned to capitalize on more upside, assuming it takes longer for the anticipated SNDL rally to play out!


In closing, Traders, probably the only time you’ll hear me say stocks are better than options is when you can buy the shares outright for less than a buck.


Your Only Option,


Mark Sebastian 

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