Sold Call Options and Short Interest Makes Petco (WOOF) a Contrarian Trade

Monday’s severe loss in pet retailer and services specialist Petco (WOOF) appears to be as clear of a warning sign as you can get. Slipping almost 11%, WOOF stock is now down over 9% in the trailing five sessions and more than 18% in the red during the trailing month. And even with the stunning turnaround that materialized in early May, Petco is up less than 7% year-to-date.

Nevertheless, it might be too early to call it quits on this intriguing meme trade. Sure, it’s never good when an equity loses 11% of value in a single day. And to be sure, several other meme stocks – including sector rival Chewy (CHWY) – suffered from volatile price action. However, it’s also true that the fundamentals of the U.S. pet industry are robust in terms of rising sales.

Further, it’s never comfortable for even the high-conviction bears to push down excessively on any one equity or asset. It’s kinda like pushing a kickboard underwater. If you lose your grip, the underlying buoyancy shoots the kickboard back up the water. That’s the risk that short traders face when going negative against a security.

It’s not guaranteed but WOOF stock could be the kickboard in the above analogy.

Unusual Options Set Up a Contrarian Signal in WOOF Stock

With Petco receiving significant attention from meme traders, it wasn’t too shocking to find WOOF stock within Barchart’s screener for unusual stock options volume recently. This useful tool identifies public equities of interest, suggesting that the smart money may be putting its funds to use. Essentially, it provides retail investors with a heads-up on compelling ideas.

Following Monday’s close, total options volume for WOOF stock reached 18,751 contracts against an open interest reading of 67,090. This metric represented a 238.89% jump from the trailing one-month average volume, implying of course greater-than-normal demand. Further, call volume hit 16,589 contracts versus puts of only 2,162 contracts.

On paper, that sounds wonderful – more calls over puts translates to bullish sentiment, right? Well, not quite. You see investors can buy and sell options. To better decipher sentiment, we must consider Barchart’s options flow screener, which filters exclusively for big block transactions likely placed by institutional investors.

Here, we find that traders have been selling calls across multiple expiration dates and strike prices. Also, last Friday, pessimistic speculators have been selling calls in addition to buying puts. It’s impossible to truly determine what options traders are thinking. However, based on the information at hand, it appears that the market professionals don’t see much upside remaining.

To remedy this situation, traders sometimes sell call options to collect income on the premium. However, if the security rises in value beyond the strike price, call buyers can elect to exercise the underlying contract. In that case, the bears will be obligated to fulfill the contract; that is, provide the shares in question.

Still, it’s not the best idea to go against the smart money. Nevertheless, in this case, a possible exemption could be made.

Keeping Tabs on Petco’s High Short Interest

At this moment, WOOF stock suffers from high short interest; 20.82% of its float, to be exact. As you might imagine, under ordinary circumstances, it’s not prudent to invest in companies that the bears are betting against.

In order to initiate a short position, a trader must first borrow the underlying equity from a broker. Subsequently, the speculator sells the shares, with the hope that they lose significant market value. If they do, the bearish bettor scoops back the equity at a cheaper price and returns the borrowed amount back to the broker. The remaining spread from the higher selling price and lower buy-back price is profit.

It sounds straightforward in principle and it is. However, irrespective of whatever happens in the market, the speculator is obligated to return the shares back to the broker. So, even if the underlying equity rises in value, guess what? The obligation to make the broker whole still stands.

In order to cut losses early, short traders must be resolute in their decision making and buy back the borrowed equity at a relatively minimum penalty. That’s because if they wait and shares swing dramatically higher, they would be forced to swallow even greater losses.

Now, the “beautiful” thing about WOOF stock is that the underlying business is shaky. In the trailing 12 months (TTM), Petco incurred a net loss of $1.32 billion. Its revenue in the period of $6.23 billion is below the prior year’s print of $6.26 billion. In theory, WOOF should go down.

However, the contrarian bulls likely know that WOOF stock features high short interest. So, they might deliberately bid up shares to spark a panic. Therefore, betting on Petco isn’t the craziest idea in the world.