In the 2022 psychological horror film “Smile,” individuals plagued by a malevolent spirit receive ominous warnings from grinning strangers, signaling their impending doom. Strangely enough, discount retail giant Dollar General (NYSE:DG) appears to be following a similarly unsettling pattern, albeit in the options market. While the consequences of ignoring this so-called “volatility smile” are not as dire as those in the movie, investors should take heed.

Despite its fundamental relevance in today’s challenging consumer economy, Dollar General delivered disappointing news to Wall Street. As noted by Barchart content partner StockStory, DG’s stock took a hit following second-quarter results that fell short of both revenue and profit expectations. Additionally, both gross and operating margins saw year-over-year declines.

To add to the gloom, the company also revised its full-year guidance downwards across the board, notably reducing its earnings per share outlook. The leadership team acknowledged the unfavorable reception, stating, “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.”

Investors are growing concerned, and options traders, often considered the “smart money,” seem to believe that Dollar General’s situation may worsen.

Reasons for Alarm for DG Stock

Given the context above, DG stock has become a notable point of interest in Barchart’s unusual stock options volume screener. Total volume reached 114,193 contracts against open interest of 150,464, with a staggering 697.99% increase in volume compared to the trailing one-month average.

Breaking down the transactions, call volume reached 45,867 contracts, while put volume reached 68,326 contracts. This results in a put/call volume ratio of 1.49, which, on the surface, implies a bearish sentiment. Furthermore, the put/call open interest ratio of 0.99, in a market with an upward bias, does not bode well for DG stock.

However, what truly adds to the unease is Fintel’s volatility smile indicator. This indicator, a graph depicting the strike price and implied volatility of options with the same underlying asset and expiration date, carries important insights into risk perception. Elevated implied volatility for both deep in-the-money and out-of-the-money options suggests that traders anticipate more significant price swings.

For DG stock, which closed at $138.50 following a 12.15% drop from the previous session, the implied volatility at a $90 strike price is at 1.01. The volatility smile becomes particularly pronounced between $90 and $120, where implied volatility stands at 0.47.

Conversely, on the higher end of the price spectrum, the volatility smile resembles more of a smirk, with implied volatility rising from 0.37 at a $170 strike price to 0.64 at $240. In essence, traders are anticipating more volatility in the $90 to $120 range compared to prices above $170.

A steeper curve below the market price is not surprising, as prices tend to drop more quickly during downturns. Additionally, implied volatility can rise for prices above the market price due to speculation and hedging against unexpected events.

However, the shape of DG’s volatility smile suggests an elevated risk of further downside. Thus, investors should exercise caution before considering a contrarian trade.

Consider the Trend

On the surface, DG stock may appear enticing, given its over 35% decline in the past six months. While it may seem like a bargain, it’s essential to consider the broader economic conditions. If the economy worsens, consumers may tighten their belts and focus on essentials, which Dollar General provides at a lower cost. This rationale makes sense.

However, it’s crucial not to go against the prevailing market trend. The narrative may seem attractive, and DG stock might indeed be undervalued. Nevertheless, those who prioritize data over dogma should pay attention to the signals from the options market. As unlikely as it sounds, smart money suggests there’s a higher risk of DG facing significant setbacks than the potential for a robust share price recovery.

Of course, even the smartest investors can make errors; they are human after all, regardless of their resources and education. If you’re determined to invest in DG stock, proceed with caution. You’ll be swimming against a strong current.

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