Wednesday, July 29, 2009

Tuesday, July 28, 2009

Rolling With My Homies

Another post on rolling spread trades can be found here.

Sunday, July 26, 2009

Wildest Dream or Worst Nightmare

The reaction to ISRG earnings certainly could have been your worst nightmare or perhaps your wildest dream. Indeed the huge gap up is precisely what volatility buyers (e.g. long straddle) covet and volatility sellers (e.g. short strangles) shun like the plague. So, if you're just getting into trading straddles/strangles and want a prime example on what can go right/wrong with earnings, well take a snapshot of ISRG and stick it on the fridge because there's a lot to be learned here.

After earnings, ISRG gapped 17% right off the bat and then proceeded to run like a scalded dog. By friday's close, a mere 2 days after the announcement, ISRG was up an incredible 31%. To say the move was unexpected would certainly be an understatement! Pre-earnings the Aug 210-140 strangle was trading around $3.00. After the insane 2 day rally, the strangle was around $18+. Supposing we thought options were overpriced and sold the strangle, we would have been down $15 per spread after 2 days (assuming no adjustments). That's 5x the potential reward... ouch!! (click to enlarge)

[Source: Edutrader]

Besides using the actual before-after prices of the strangle, another method for analyzing the poor job the options market did in anticipating (and properly pricing in) this earnings gap is by taking a before/after look at volatility. The ISRG implied volatility charts show that pre-earnings, options were certainly pricing in an uptick in realized volatility (IV = 60%, 30 day HV = 40%), but certainly not enough as current-post earnings 30 day HV sits around 80%. In other words, the options board accurately predicted that the underlying was about to realize more volatility than it had in the recent past. However, they failed to price in the magnitude of just how much more volatile ISRG would actually be.

[Source: IVolatility]

The reaction to ISRG announcement is the exact scenario that cynics use as ammo in arguing against selling strangles. After all, one loss such as ISRG could wipe out ten trades worth of gains. Which highlights an important point>> Successful option trading isn't so much your win-loss record as it is your trade management.

In other words, I could have a trading system where I short strangles into every single earnings announcement. Although my winning percentage may be around 85% it doesn't mean I'm going to be a slam dunk winner. Suppose I make $200 on the average winning trade but lose $1200 on the average losing trade. Well, my expected return is still negative ($200 * .85) - ($1200 * .15) = -$10, thus in the long run I'd be a net loser.

From ISRG I think we can learn two important lessons. First, proper trade and money management are integral to becoming successful trader- regardless of the strategy. Second, becoming a successful option trader requires flexibility in one's approach. During certain market environments you may want to be a net buyer of options (or volatility), while in others you'll want to be a net seller of options (or volatility). Neither one works all the time!

Next time we'll delve further into these two lessons...

Wednesday, July 22, 2009

Earnings Intuition

Although the VIX is quickly coming in line with recent realized volatility (VIX at 23 vs. SPX 30 day HV at 22), there are still a few individual stocks that have seen their options implied volatility ramp up, or at least trade at a notable premium to HV, going into earnings. As we move further into the heart of earnings season it's becoming easier to find potential candidates ripe for short volatility plays. Tonight's earnings calendar is no exception- as I've found a few stocks that are worth looking at. Let's highlight Intuitive Surgical (ISRG).

Currently ISRG 30 day HV is sitting at 40%, while 10 day HV is at 35%. (click to enlarge)

[Source: EduTrader]
Current IV (gold line) is nestled around 60%- an obvious premium to HV. As usual, the 64k question is whether or not this higher IV is warranted. So far this earning season volatility sellers have had the upper hand and been rewarded the majority of the time (e.g. GOOG, AAPL, RIMM, APOL, etc...). Assuming that will also be the case with ISRG, let's take a look at two short vol strategies: strangle and iron condor.

[Source: IVolatility]

Short Strangle:
Short Aug 140 put @ $1.90
Short Aug 210 Call @ $1.20
Max Reward = $3.12
Max Risk = Unlimited

By shorting an OTM call and put, we're essentially betting that despite the earnings announcement and the gap that generally ensues, we still believe ISRG will stay between $210 and $140. Although 210 and 140 are the short strikes, technically the breakevens for the trade are $213.12 and $136.88

[Source: EduTrader]

To those that are uncomfortable with the theoretical unlimited risk inherent with short strangles, as well as the larger margin requirement, you may consider an iron condor instead.

Iron Condor
Short 140-130 put spread @ $1.10
Short 200-210 call spread @ $1.00
Net credit $2.10
Max Risk: $7.90

[Source: EduTrader]
I lowered the short call strike to 200 on the call spread versus 210 in the short strangle. As you can see the iron condor affords less net credit, but also much less risk. In addition to ISRG, Chipotle Mexican Grill Inc (CMG) and F5 Networks Inc. (FFIV) also have options with a notable difference between IV and HV.

Monday, July 20, 2009

Anything Can Happen

The recent strength, seemingly from nowhere (as argued by most chartists), experienced by the market, has caused me to do a bit of introspection on the way I perceive trading opportunities. Like most traders, I seek to enter the market only when I have a discernible edge in my favor which justifies taking on risk.

How we each individually identify what constitutes a trading edge invariably differs depending on our various approaches. For directional trades I tend to rely primarily on charting and other indicators to suggest there is a high probability of the market moving a specific direction. In my experience predicting stock direction using price patterns isn't as much of a slam dunk winning approach as is touted. One other avenue I utilize in identifying tradable opportunities within the options arena is playing volatility by either buying options that seem under priced or selling those that seem overpriced.

It's important to only enter the market place when you have an edge because it allows you to trade with a reasonable expectation that in the long run you're going to be profitable. A major mistake that traders commit is becoming too confident in their ability to accurately predict which way the market is going to move. This tends to happen especially after experiencing a string of winning trades. Unfortunately becoming too confident can result in making some serious trading errors such as over leveraging oneself. Being so sure that something is going to happen- and then experiencing it not happening can be quite painful emotionally (take the failed head and shoulders pattern for example).

One of the best books I've read on trading psychology and obtaining an objective perspective is Trading in the Zone by Mark Douglas. In it he expounds on the idea that emotional pain is the byproduct of unfulfilled expectations and to become objective traders we must truly accept that anything can happen. So, emotional pain can be somewhat mitigated by having proper expectations. For example, rather than expecting (and convincing myself that I know) the market will move a certain direction- it would be more objective to merely expect movement (up, down, or sideways). Then I'll never really be disappointed, as my expectations will always be fulfilled.

The following two statements sum up my thoughts:

More confidence in my ability to predict future = more emotional and financial pain when I'm wrong
Truly believing that anything can happen = less emotional and financial pain when I'm wrong

Which route would you rather take?

Thursday, July 16, 2009

IBM Earnings

IBM was the other tech behemoth to report earnings tonight. In assessing volatility and the options board, I didn't see much of an edge in playing the earnings announcement.

However, it may prove instructive to explain my rationale.

Although RIMM and APOL experienced a surge in implied volatility into earnings, that IV pop was largely absent in GOOG and IBM. While GOOG July options at least had some juice to play with, IBM July options weren't giving us much rope at all. We'll look at a few plays in a minute, but first let's break down volatility.

Current 30 day HV is at 22%. IBM has rallied 10% over the last week causing the shorter term measure of 10 day HV to rise considerably higher to 35%.

At the end of the day, IBM Implied volatility was sitting around 26%, a slight premium to 30 day HV, but a considerable discount to 10 day HV. This was one of the reasons why options weren't a slam dunk sell.
IBM closed today at $110.64. The July 115 calls were at a mere $.40 with the 105 puts at $.30. So selling strangles was out of the question- not enough premium.

I suppose you could have considered selling an ATM July straddle by shorting the 110 call and put for about $3.70, but that sure doesn't give us much breathing room. ($106.94 - $114.34). Were IBM to gap up or down more than 3% you'd be toast-

Assuming you hadn't played the July Straddle, August options would have been my next stop. If I had to I probably would have entered a short strangle or iron condor using the 120 calls and 100 puts.

It seems like the VIX Smack Down we've experienced has served to dampen some of the pre-earnings ramp up we historically see in individual stocks implied volatility. We're yet to get into the thick of things with earnings, so we don't have that large of a sampling size, but it seems as if we've seen quite a tempered reaction to most companies earnings (INTC being the exception). This would lead me to deduce that the lower IV going into earnings has been justified.

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Google Earnings

Tech giant GOOG is reporting earnings tonight after the bell, so let's take a look at what the options are pricing in and spotlight a few potential plays.

Remember, when assessing implied volatility we're trying to get a sense of whether or not options seem over, under, or fairly priced. For example, if current implied volatility on GOOG 30 day options is sitting around 40% and I expect GOOG stock price will only realize 10% volatility over the next 30 days, I would be of the opinion that GOOG options are overpriced. As such, I'd rather be an option seller(via maybe a short strangle or condor) than buyer. On the other hand if current IV is sitting at 10% and I expect GOOG stock price to realize 40% volatility over the next 30 days, I'd be of the opinion that options are too cheap. Thus, I'd rather be a buyer of the options (via a long straddle or strangle).

Currently 30 day HV on GOOG sits at 25% and 10 day HV sits at 32%.
A look at the implied volatility chart below shows that current IV is at 33%; a 7 pt. premium to 30 day HV, but seemingly right in line with 10 day HV.
Because July options expire this weekend, we can take a look at the July straddle to see how much of a move is expected in GOOG tomorrow.

Currently GOOG is trading around $440 and the ATM straddle (long 440 call + long 440 put) is trading at $21.70. For buyers of this straddle to have a profit they need GOOG to be above $461.70 or below $418.30. This requires a $21.70 or 5% upward or downward move. See the graph below:
So, if you think the options board is underpricing July GOOG options and that GOOG will gap up or down more than 5%, you may just want to be a buyer of this straddle. Keep in mind, although the volatility chart I showed previously has GOOG IV at 33%, per IVolatility their IV Index is

Because the 1 day remaining in July expiration will be drastically affected by GOOG earnings, the July options are trading at a much higher IV (85%), than is implied by the IV Index (33%).

So what if I think July IV is too high? Well, then I'd want to do a short volatility strategy, such as a short strangle or condor. Because GOOG is such a high priced stock, short strangles will have a pretty high margin requirement as well as a lot of theoretical risk- so let's review an iron condor instead.

Iron Condor:
Sell July 470-480 Call Spread @ $.60
Buy July 400-390 Put Spread @ $.65
Net Credit = $1.25
Max Risk = $8.75
To profit we need GOOG to remain between 400 and 470, which means it can't gap up more than $30 (7%) or down more than $40 (9%). If you think a gap that large is not in the cards, then entering a condor may be prudent. If you wanted to widen the range of the condor you may consider using August options instead of July-

By the end of today, GOOG may be trading much higher or lower than $440- which may necessitate changing strike prices on the aforementioned trades.

Wednesday, July 15, 2009

Markets We Love to Hate

The market has a knack for teaching valuable lessons to those willing to listen. Then it perpetually, and oft times painfully, reminds you lest you get too lackadaisical or complacent. Rather than getting emotional and subjective when the market moves adversely, try to be objective and find out ways you can improve. Here's a few lessons I've been reminded of in the past few days.

1. Don't press your shorts too hard after the market has fallen into oversold territory.
The time to get aggressive in entering bearish positions is after a market rally, not following a selloff. Those bears who got a bit too greedy in loading the boat four or five days ago have gotten their heads handed to them during this rally. Furthermore, they then become so caught up in licking their wounds that they're too gun shy to jump back in when the rally has exhausted itself and the market is ready to roll over again. It certainly takes some guts to add bearish positions when you're existing ones have been poleaxed.

2. Don't get discouraged if you lose when the market occasionally travels the path of most resistance. Remember trading is about probability, not prediction. When placing directional trades I'm continually trying to forecast the path of least resistance for the overall market. Assuming I can do this, I should find myself on the right side of the market the majority of the time. It is the market movements that go against the grain, those that take the past of most resistance that often hurt the most. For example, I would guess that last week most traders would have bet the market wouldn't have retraced 100% of it's drop from 930 to 875 (myself included). Well.. it just did, much to the chagrin of the bears.

3. There's nothing wrong with being; there is something wrong with staying wrong! If you found yourself on the wrong side of a lot of this week's market movements, survey how much you lost on your trades. Did you lose more than you planned on losing? Was it a large % of your portfolio or a small %? Money management isn't a very sexy subject and doesn't receive a lot of time in the spotlight, however it is probably the most important factor to successful trading. To become a successful trader you have to last. To last you must protect your trading capital and that requires an unwavering discipline in adhering to your exit plan and only losing a small % of your portfolio in any one losing trade.

JPMorgan Chase (JPM) has earnings tomorrow morning followed up by IBM and Google (GOOG) in the evening. I didn't really look at JPM too closely, but it doesn't look like there was much of a volatility edge heading into earnings. I'll take a look at IBM and GOOG in tomorrow's post.

Tuesday, July 14, 2009

Vega Part Deux

In our first installment on Vega I reviewed the basics of implied volatility and its effects on option premiums. The key take away was:

As implied volatility rises, options become more expensive.
As implied volatility falls, options become less expensive.

Gaming volatility necessitates a basic understanding of how to measure implied volatility's effect on option premiums. The greek vega allows us to do just that, so today's post will focus on reviewing its basic nuances.

Here are links to other relevant posts on the greeks:

Vega is used to quantify or measure an option's sensitivity to a one point change in implied volatility.

Consider the affect of Vega on the following two positions on XYZ which is trading at $60 and has an implied volatility of 50%.

Long 60 Straddle
Long 60 call @ $3.00; Vega = +.20
Long 60 put @ $3.00; Vega = +.20
Net Debit = $6.00
Net Vega = +.40

Suppose IV increases from 50 to 55%. How much will our position increase in value? With a position Vega of +.40, we can expect our position to increase by $2.00 (.40 x 5).

Short 70-50 Strangle
Short 70 call @ $1.00; Vega = -.10
Short 50 put @ $1.00; Vega = -.10
Net Credit = $2.00
Net Vega = -.20

Suppose IV decreases from 50 to 45%. How much will our position increase in value? With a position vega of -.20, we can expect our position will increase by $1.00 (.20 x 5).

Vega is positive for long options and negative for short options

When you buy an option, you are essentially buying or going long volatility. A long option position is one that seeks volatility (both realized and implied). Think about the last time you bought a call option. Were you thinking, “Man, I hope this stock stays stagnant!” Or was it more along the lines of, “Boy, I hope this stock busts a move so I can make some money!” Odds are it was the latter. Why? Remember when you’re long an option you want it to be worth as much as possible at expiration. Thus, the more a stock moves the higher your chances for raking in profits. As option owners (long vega) we not only like to see a stock’s realized volatility pick up, we also like to see implied volatility increase because it increases the value of an option.

When you sell an option, you are essentially selling or going short volatility. A short option position is one that shuns volatility. As an option sellers (short vega) we usually want the option to expire worthless. What were your thoughts last time you shorted an OTM call or put option? You were probably hoping the stock would remain relatively quiet (i.e. exhibit low realized volatility). As realized and implied volatility diminish, the option value becomes worthless much quicker.

Vega is highest for long term options and lowest for short term options

If implied volatility doubles, which do you think it will affect more- an option that expires tomorrow or one that expires in a year? In other words, do you think implied volatility doubling has more ramifications for the underlying stock in the next day or over the next year? The obvious answer is over the next year. As such, long term options are more sensitive to changes in implied volatility than short term options.

Take a look at Goldman Sachs options below, focusing on the vega of each option. Currently GS is trading around $145 and we’re looking at the 145 strike call for 5 different expiration months (click to enlarge).

July is .05, Aug is .18, Oct is .28, Jan 2010 is .40, Jan 2011 is .67. A 1% increase in IV would increase the July option by $.05 and the Jan 2011 option by $.67- quite a difference!

Vega is highest for At-The-Money options and lowest for In-The-Money or Out-of-The-Money

Like Theta and Gamma, Vega also peaks in ATM options. Take a look at August options on GS below:

Vega peaks at .18 in the 145 strike which is ATM

So based on the previous two principles, buying a long term, ATM straddle (long call + long put) would be the purest long volatility bet. Conversely, shorting a long term, ATM straddle (short call + short put) would be the purest short volatility bet. Now, that's not to say it's the best way to play volatility, only the purest.

Vega is the same for calls and puts

For the same strike-same month call and put you’ll typically find that vega is the same for both options.


Friday, July 10, 2009

Earnings... the Wrench in the Theta Clock

Consider this:

Does theta work like normal when there is an earnings announcement between now & expiration? In other words, If I’m considering a positive theta trade (short strangle, iron condor, calendar spread, etc...) by selling July expiration options; can I expect time decay to erode away at the value of these front month options if there is an earnings announcement right before July expiration?

The answer is usually no.

GOOG serves as a good case study as it reports earnings next Thursday, 1 day before July options expiration. Would it be wise to place a July short strangle today in an effort to gain exposure to 4 or 5 days of time decay, or should we wait until next Thursday to place the trade?

Truth is when an earnings announcement release occurs close to expiration, the effect of time decay is negligible. Thus, although Theta increases exponentially as expiration approaches, the price of an OTM call or put may remain higher than Theta would lead you to believe.

In addressing this subject in The Volatility Edge in Options Trading, Jeff Augen asserts: “The effect we are discussing involves a decoupling of option prices from the current behavior of the underlying security. This decoupling seems rational when you realize that options, like all securities, are priced by the aggressiveness of buyers and sellers. Many investors falsely believe that option prices are set according to the familiar mathematics of volatility and time. In fact, the opposite is true; prices are set by traders who buy and sell contracts using the mathematics as a guideline… It is completely reasonable for the two to decouple, and that is often what happens when earnings are approaching.”

Let’s look at an OTM call option on GOOG to illustrate. GOOG is currently trading around $414.50. The July 420 call is at $10.80 and has a theta of -81, meaning that theoretically this option should lose $81 a day due to time decay. Utilizing an Options Calculator we can forecast how much the July 420 calls should decline in value day by day until expiration. We’re going to assume GOOG stock price ($414.50) and implied volatility (54%) remain constant throughout the exercise:

As the table illustrates, we can reasonably expect OTM GOOG options to decay rapidly into options expiration. However, this will not be the case with July expiration. As Jeff Augen points out, there is a “decoupling of option prices…when earnings are approaching”. We’ve mentioned previously that option traders aggressively bid up option premiums in anticipation of a company’s earnings release. This aggressive demand drives up implied volatility and keeps the July 420 call option value higher than what the table above implies. Although the 420 calls are currently trading with an IV of 54%, odds are IV will be much higher next Thursday in anticipation of the large gap that often occurs in GOOG’s stock price after earnings.

In addition to the negligible effect of time decay, this continual rise in implied volatility in anticipation of an earnings release serves as another reason as to why it is prudent to hold off on entering short volatility strategies until the day before the earnings announcement. After all, no sense in entering a short strangle on GOOG(or any stock for that matter) right now if it can be entered in 4 or 5 days at much higher volatility levels.

For the aforementioned reasons, I generally wait until the day of earnings (assuming they report after hours), or day before (if they report the following morning) to enter any short volatility strategies.

So You're Telling Me There's a Chance...


Options Pricing...

It's all about the probabilities...

So I just took a stroll over to a new options blog, by
Dean Mousher's, (Hat tip VIXandMORE) and rather enjoyed the information
he has put out so far. I've lightly highlighted the role that the laws of probability
play in pricing an option in my Delta and Probabilities post. For those of you
looking to expand your understanding of some of the concepts I alluded to
such as normal distribution, volatility and it's influences on option prices, there's
a 45 minute video that gives an in depth overview of these concepts.

Thursday, July 9, 2009

Finding Volatility

I received a question on what sources are available that offer implied volatility charts. So I offer up a few sites I'm aware of.

1. IVolatility The volatility charts I typically post on this blog originate from this website. Although you have to join the website to gain access to the volatility charts, it is free. These charts can also be accessed via the CBOE website. Under the "Trading Tools" section go to the IV index. The IV Index is provided by IVolatility so it's essentially the same as except you don't have to sign up.

2. ISE The International Securities Exchange website offers volatility charts, albeit not as comprehensive as IVolatility.

I've yet to figure out how to change the layout of the ISE charts and volatility (if it's even possible), so if someone knows how, feel free to enlighten me.

3. OptionsXpress OptionsXpress volatility charts aren't near as clean as IVolatility, but hey- there better than nothing.
I'd venture to say most charting platforms out there offer the ability to add historical volatility studies to the chart. Then there's probably a sub-set of those that also offer implied volatility (ThinkorSwim comes to mind)
4. Recently LiveVol has introduced a new platform with volatility and order flow analysis galore. Thus far I've enjoyed the layout of their platform immensely.

If you know of any other free services or brokers out there offering IV charts, let me know and I'll add them to the list.

Chevron On Deck

Chevron earnings on deck tonight at 5 PM EST. Let's take a look at what the options board is pricing in. While current IV (gold line) sits around 35%, 30 day HV is residing around 26%. So the options seem to be expecting (e.g. pricing in) a decent
up tick in the stocks realized volatility; at least more so than the last few earnings plays I've look at (FDO, AA). July expiration options have a mere 6 days left until expiration, so analyzing these front month options may give us a better glimpse as to what type of move CVX is expected to make off of tonight's earnings.

CVX is currently trading around $63. The front month strangle (July 60 put +July 65 call) is only trading around $.85. Those buying the strangle would want to see CVX above $65.85 or below $59.15 by next Friday (assuming they hold all the way to expiration). That's about a 4.5% move up and a 6% move down. Not really a blow-out move by any stretch of the imagination.
August expiraiton options have quite a bit more premium to play with, providing more flexibility in structuring short volatility trades into earnings. Let's consider a short Aug 55-70 strangle.

Sell Aug 70 call for $.50
Sell Aug 55 put for $.65
Net Credit = $1.15

Bringing in $1.15 credit puts the upper breakeven around $71.15 and the lower breakeven around $53.85 (assuming you hold to expiration).

As mentioned in previous earnings post (APOL, RIMM), we're betting CVX moves less than expected and volatility gets crushed post earnings (perhaps closer in line to current 30 day HV of 26%).

Those wanting some protection in case CVX gaps too much could consider buying an AUG 50 put and AUG 75 call to create an iron condor. The trade-off is you're giving up about $.30 of the strangle's net credit to acheive the limited risk.

Wednesday, July 8, 2009

Viewer Mail Follow Up

In yesterday's Viewer Mail post, I reviewed FDO earnings and highlighted why it didn't present any compelling short volatility opportunities. Turns out that assertion was correct so far... Yesterday FDO closed at $27.75 and today it opened at $30.25. The $2.50 or 9% gap would have made the Aug short strangle I highlighted unprofitable. Yesterday the Aug 25-30 short strangle was trading at a $1.45 credit. As of 1 hour into the trading day it's currently trading at $2.10 with FDO already above the short call strike price ($30).
Now, that's not to say it can't turn out to be a profitable trade if FDO were to start filling in its gap. But right here right now, you'd be down about 44%.

This is a prime example as to why you can't just short volatility into every earnings announcement. Some times the options market succeeds at fairly pricing in the uptick in realized vol (read: gap in stock price) that occurs because of earnings. Other times it may even underprice the move.

Bottom Line: When assessing earnings plays make sure there's enough of an edge before jumping into any short vol strategies, such as condors or short strangles.

Tuesday, July 7, 2009

Viewer Mail

I received an interesting question in regards to playing earnings announcements with iron condors or short strangles. The gist of the question was as follows

“When a company has an earnings announcement close to options expiration, do you use front month options in constructing a trade or do you use two month options?”

The answer is it depends. There are certain trade-offs to using front month vs. second month options.

One of the biggest factors influencing my decision is whether or not there is sufficient premium in front month options to make the trade feasible. In the case of RIMM, earnings came out the day before options expiration presenting an interesting one day play on front month options. Due to the high implied volatility in RIMM options, one day OTM options still possessed a surprising amount of value. As such, there was definitely enough rope in constructing a front month strangle or condor.

Tomorrow morning FDO (Family Dollar Stores) reports earnings. FDO closed today at $27.75- A glance at the options chain shows a front month strangle (short Jul 25 put + short Jul 30 call) is trading at $.55 net credit. The individual bid-ask spread of the trade is shown below.

Jul 25 Put .20 x .30

Jul 30 Call .30 x .35

As you can see, the front month short strangle provides insufficient credit. To me, the reward is simply not worth the risk. With the front month out of the equation, I would then look at two month options to see what’s available. On a side note - because FDO is a cheaper stock with fewer strikes to choose from, we aren’t really presented with much flexibility in putting on a front month trade (short strangle or condor). This is why I prefer to play these types of trades on higher price stocks or those that at least provide more strikes to choose from. The two month (Aug) strangle definitely provides adequate credit ($1.45) to justify doing the trade.

Aug 25 Put .60 x .70

Aug 30 Call .75 x .85

So, the first factor to consider in choosing months is the net credit provided. The next factor would be whether I’m comfortable with the range. Although the Aug short strangle provides enough credit to make the trade feasible, I personally wouldn’t be comfortable with the range. With the stock sitting at $27.75, either strike is only 8% away. I’d prefer a wider range especially given that we have about 6 weeks to expiration. Furthermore, the Aug 30 call has a delta of .33 and the Aug 25 put has a delta of .22. That puts my probability of profit at 45% (1 - .33 - .22), which certainly doesn’t excite me.

Now just because FDO front month options weren’t ripe with opportunity doesn’t mean you won’t find other trades that can use front month options. When you do it’s important to consider the greek differences between front month options vs. longer dated ones.

Front Month: Higher Theta, Higher Gamma, Lower Vega

Second Month (or longer): Lower Theta, Lower Gamma, Higher Vega

Given the differences listed, one must ask themselves which scenario they prefer. Second month options lessen ones exposure to gamma and increase their sensitivity to volatility crush (higher vega). However, they also provide a lower rate of time decay. Conversely, front month options increase ones exposure to gamma and somewhat lessens ones exposure to volatility crush (lower vega). But, do offer a higher rate of time decay.

In the end you must make the call.

I occasionally do intraday updates on Twitter with my thoughts on the markets or trades I’ve mentioned. If you’re not already following me on Twitter, you can do so here.

Monday, July 6, 2009

Buy the Dips, Sell the Rips

I don't tend to comment on TA on this blog much but wanted to shed some insight on my approach to charting.

Technical Analysis can be as complex or as simple as you make it. My opinion of TA is less is more. On my initial venture into charting I naively thought as I progressed as a trader I would continually consult more and more indicators in an effort to receive maximum confirmation in forecasting the future price direction of the stock. Funny thing is I've come full circle in my approach. At first I kept it simple by using a candlestick chart and volume. As I learned the intricacies of indicators, the Stochastic and MACD become my bread and butter with the occasional glance at the Chaikin Money Flow and RSI. However, as my understanding of the importance of price action (trend, support/resistance) and volume grew I began shedding the indicators one by one until I was back to using candles and volume (with the occasional glance at moving averages)

Now I actually get somewhat perturbed when I see someone's screen chalk full of indicators-

Can you say OVERKILL??

For directional trades, all I really worry about are the current trend, momentum, and key support or resistance levels. I believe many traders would benefit from using less, not more.

In my opinion, the following mantra is over quoted, and under utilized.
Buy the Dips and Sell the Rips

The gist of the statement is to trade with the trend: buy dips in up trending stocks and sell rips in down trending stocks.

Now the tricky part is knowing when the dip or rip is done. Sometimes stocks dip or rip too much and put the existing trend in peril. That's the beauty of selling OTM credit spreads - you have a wide margin of error, so that if the stock rips say 2,3, or more additional days after you sold an OTM spread, you still have quite a bit of room before you're crying for your mama.

Using the SPY as our underlying, let's analyze a simple way to utilize credit spreads in "buying the dips and selling the rips".
1. When the SPY is in an uptrend, I will use dips as opportunities to sell OTM put spreads
2. When the SPY is in a downtrend, I will use the rips as an opportunity to sell OTM call spreads
3. When the SPY is trendless, I will sell iron condors (OTM bear call + OTM bull puts)

Now as with any trading system or approach, the devil is in the details. Obviously there will be times when you will be wrong, and that's where proper trade and money management come into play. However, I see way too many people overcomplicating charting and trading by either using way too many indicators and trying to get the stars to align in the sky before pulling the trigger OR spending way too much time searching for trade find perfect individual chart setups. It can really be as simple as using the same underlying (like the SPY) month to month and simply using strategies such as credit spreads to place bullish/bearish/ or neutral trades.

My most successful 6 month spurt came around October 2007 to March 2008, when I used each and every rally in the RUT to sell call spreads. Because the RUT and the entire market were in the midst of a downtrend, I was in "sell the rip" mode. And continued to do so until it didn't work anymore.
I showed a trade journal of a recent RUT bear call spread (view it here). I've subsequently entered other July bear call spreads that have all worked great. Using ""if it ain't broke, don't fix it!" as my current investing thesis, what do you think I'm going to continue to do until it doesn't work anymore?

Thursday, July 2, 2009

APOL follow up

Monday's post contained an overview of two potential plays on APOL earnings. Let's see they played out.
Short Strangle:
Sell July 60 put @ $1.05
Sell July 75 call @ $1.10
Net Credit = $2.25

Because of the 8% gap up, the short July 60 puts could have been closed out around $.10 Tuesday morning resulting in a $.95 gain. And what may be surprising to some, despite the up gap the 75 call didn't even rise in value. Had you held it until today, you could have closed it out around $.30, resulting in a $.70 gain. All told, the short strangle would have profited about $1.65 in a few days. Not too shabby indeed! Once again, the primary dynamic that goes into making a short strangle profit is the huge volatility crush that occurs post earnings. We highlighted this with RIMM's earnings, but let's take a look at the APOL vol chart.

Remember, the gold line is implied volatility, the blue line is 30 day historical volatility. Pre-earnings the implied volatility was perched around 55%, quite a hefty premium to the 30 day HV of 40%. As usual, IV experienced a precipitous fall from 55% to about 40% post earnings. This vol crush is the dynamic that should take the most credit for producing our profitable trade. With the vol crush in the spotlight it should make sense why sometimes a stock undergoes an 8% gap up and OTM options (e.g. 75 call) not only don't increase in value, but often decrease in value. That's generally why it's a suckers bet to buy OTM options into an earnings announcement. They're typically so juiced up on IV that the expected gap is already baked in the cake.

Iron Condor:
Sell July 60-55 put spread @ $.77
Sell July 75-80 call spread @ .65
Net Credit = $142

The condor had a similar outcome to the short strangle. Tuesday morning you could have closed out the bull puts immediately at $.10, locking in a $.67 gain. Had you waited until today to close the call spreads, you would have been able to exit around $.30, locking in a $.35 gain on the call spread. All told that's a net profit of $1.02. Considering the margin requirement was $3.82, that's a 26% return in a few days.

Now before you get too excited to go running out to get doped up on copious amounts of condors & strangles into earnings, keep in mind that there are circumstances where the stock gaps much more than expected. GOOG April 2008 earnings comes to mind- it resulted in almost a $100 gap. That is precisely why good money management is paramount. If you're properly spread out over multiple trades, the occasional extreme gap shouldn't kill you. So don't overdose (e.g. risk too much capital) in this type of trade. In addition, some options implied volatility doesn't ramp up as much into earnings as others, so not every announcement presents a playable opportunity.