In the 2022 psychological horror film “Smile,” people affected by a murderous spirit are warned about their impending doom through passersby ominously grinning at them. In some ways, discount retailer Dollar General (DG) has also inked a similarly unsettling pattern, in this case in the options market. While the consequences of ignoring this so-called volatility smile isn’t as dire as the plotline in the aforementioned film, investors should nevertheless heed the warning.
Although a fundamentally relevant enterprise given the troubles that the consumer economy faces currently, Dollar General had some bad news for Wall Street. As Barchart content partner StockStory pointed out, DG stock plummted as the underlying retailer posted second-quarter results that missed both top and bottom-line targets. In addition, gross and operating margins declined on a year-over-year basis.
As if said disclosure wasn’t putrid enough, management also lowered the company’s full-year guidance across the board. In particular, notes StockStory, the retailer delivered a jarring reduction in outlook for earnings per share.
The leadership team acknowledged how ugly the reception would be. “While we are not satisfied with our overall financial results, we made significant progress in the second quarter improving execution in our supply chain and our stores, as well as reducing our inventory growth rate and further strengthening our price position.”
It might be an overreaction. However, options traders – otherwise known as the smart money – apparently believe that circumstances might worsen for Dollar General.
DG Stock Ominously Smiles at Investors
To no one’s surprise given the above context, DG stock represented a top “highlight” in Barchart’s screener for unusual stock options volume. Specifically, total volume hit 114,193 contracts against open interest of 150,464. Further, the delta between the Thursday session volume and the trailing one-month average metric came out to 697.99%.
Breaking down the transactional details, call volume reached 45,867 contracts while put volume hit 68,326 contracts. This pairing yielded a put/call volume ratio of 1.49, which on paper (and outside other context) implies bearish sentiment. Also, the put/call open interest ratio is 0.99, which given the upward bias of the market isn’t a great read for DG stock.
However, what really unsettles the narrative is Fintel’s volatility smile indicator. Per the investment resource, a volatility smile is a common graph shape that results from plotting the strike price and implied volatility (IV) of a group of options with the same underlying asset and expiration date.
One of the basic takeaways of the volatility smile centers on risk perception. If IV spikes for deep in-the-money (ITM) and out-the-money (OTM) options, such activity may indicate that traders anticipate more extreme price movements in the underlying security at the targeted price levels.
For DG stock – which closed at $138.50 on Thursday after dropping 12.15% against the prior session – the IV at strike price $90 stands at 1.01. Further, the “smile” is particularly acute from $90 to $120, where IV sits at 0.47.
On the other side of the price spectrum, the volatility smile is more like a smirk, with IV rising from 0.37 from strike price $170 to 0.64 at $240. Put another way, traders anticipate much more volatility between prices $90 to $120 than they do $170 and beyond.
Fundamentally, a sharper curve below the open market price of a security isn’t unexpected because prices tend to accelerate quicker during downturns than they do during upswings. And IV can rise at prices well above the open market price due to speculation as well as hedging against tail risks stemming from powerful, unexpected developments.
Still, the shape of DG’s volatility smile suggests a heightened risk for continued downside. Therefore, investors shouldn’t be too quick on jumping on the contrarian trade.
Don’t Fight the Tape
On a personal level, DG stock does look attractive given the over 35% loss in the trailing six months. Sure, it’s an ugly print. However, if economic conditions worsen, consumers will likely cut their discretionary spending and focus on the essentials. Dollar General provides said essentials but at a cheaper price. It seems so reasonable.
At the same time, traders shouldn’t fight the tape. Yes, the narrative does seem incredibly attractive. And maybe DG stock truly is discounted. Nevertheless, if you’re a believer in data superseding dogma, you should consider the above options rumblings. As wild as it sounds, the smart money believes there’s much more risk that DG can crumble badly than there is a potential opportunity in shares rising robustly.
Of course, the smart money can make bad calls – they’re human at the end of the day, no matter their resources and education. So, if you must buy DG stock, do so but do so carefully. You’ll be swimming against a very strong current.
On the date of publication, Josh Enomoto 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. For more information please view the Barchart Disclosure Policy here.
