Full Disclosure Finance

By Andrew

Watching CNBC’s Fast Money last week one of the analysts discussed an interesting trade for January based on the theory of Options Backwardation. Backwardation occurs when the implied volatility of an option, which is used in the calculation of the option’s premium, is higher in the near term than in the long term. Meaning that you are paying a higher premium for an option contract in the front month than in the future months. Normally the premium for an option increases as you go out further in time. Options Backwardation can be due to an expected catalyst in the stock such as upcoming earnings, or a new product anouncement. However, absent of these known events the unusual premium price can be an indicator of a sharp rally in the stock price in the near term.

The stock that was mentioned in conjunction with this trade was Echelon Corporation (ELON). Echelon develops, markets and sells system and network infrastructure products to home, building, transportation, and automotive manufactures. Options Backwardation was identified in ELON on December 31st, 2007. The elevated January premium of the options chain, relative to February and March, indicates a possible rally in the stock before the 3rd friday of January (the options expiration date). I don’t know how reliable this strategy is, but I intend on keeping an eye on ELON for education purposes. I’ll keep you posted.

Here is the link to the CNBC video where the Fast Money traders discuss this phenomenon.