Monday, August 31, 2009

The Over-Write

Viewed most of last week's Options Action and I've got another over write to kick around. For those of you that missed last Monday's Options Action post, check it out here. For those not up to snuff on options vernacular and the sometimes confusing synonyms that abound in the financial markets, covered calls are oft times referred to as buy writes or over writes. Remember a covered call consists of being long 100 shares of stock (or increments of 100) and short a call option.

Covered Call = By selling a call option I'm obligating myself to sell 100 shares of stock. That obligation is "covered" by a long stock position.
Buy Write = I've bought shares of stock and am writing (think selling) a call option against my stock position
Over Write = I've bought shares of stock and am writing a call option with a strike price above (over) the current stock price.

Because we still find ourselves in an environment where options are overpricing the volatility we're actually realizing day to day, another covered call was suggested. To setup the trade the following was said (I'm paraphrasing):

"Even though implied and realized volatility are lower than they've been in a while, it doesn't mean it's not a good time to do an over write strategy in the right name."

To that I say, yes and yes. There's no doubt the VIX (which I'll use as a proxy for implied vol across the board), and the day to day moves we've realized recently have been much less than 3 to 6 months prior. But as Adam Warner at DailyOptionsReport reminded in his recent post on AIG:

" Options volatility [read: implied volatility] is only relevant in comparison to the volatility of the underlying. No one knows the volatility of the underlying going forward, so the best clue around (barring an expected news event) is the volatility of the recent past [read: historical volatility]."

VIX could be at 10%, an extremely low reading to be sure, and SPX options could still be overpriced vs. realized volatility. For example, we could buy SPX straddles at 10% volatility, guessing that options were underpriced, but if the SPX only realized 5% through the duration of that SPX straddle trade we'd probably have lost money.

Back to Options Action- the suggestion was selling an Oct. 40 call on National Oilwell Varco (NOV) for $1.50. From a volatility perspective I like this better than the NSC suggestion from last week. Take a gander at the vol chart:
Current IV sits around 47% with 30 day HV at 43%. As you can see, both are the lowest they've been for the last 6 months (were I to display a 1 year chart you'd see they're the lowest in about a year). But as mentioned previously, although they're low, IV still overprices recent realized vol. Now you may quibble that there's not a huge premium of IV vs. HV, but I'd argue there's certainly enough to cause me to agree with selling options as opposed to buying.

I'll expound on the benefits of over writes in subsequent posts-

Wednesday, August 26, 2009

Farmer in the DELL

Along with the VIX, Dell Inc. (DELL) also received some face time in Friday night’s Options Action. With Dell earnings scheduled for Thursday night after the bell, the Options Action crew highlighted a few earnings plays. The consensus across the panel was Dell options weren’t pricing in that much of a move, so both strategies recommended were of the option buying variety. Remember, from a volatility stand point we prefer to buy what seems to be underpriced options and sell those that seem overpriced. One pundit recommended a long strangle, while the other a straight call option purchase.

Did they get it right? Are options pricing in a small or large move? Let's analyze the volatility chart:

[Source: IVolatility]

Current 30 day historical volatility sits around 40%. Implied volatility is around 45%. So we do have IV pricing in a small uptick in volatility, but not much. When comparing current implied vol levels to its 1 year historical range it is sitting close to 52 weeks lows. With that backdrop, yeah I suppose you could say options aren't really pricing in that much of a move, but it certainly seems justified given the implosion in realized vol we've seen not only in Dell, but across the board in most all stocks.

On to the recommended strategies...

Pundit #1 recommended a Sep 14-15 strangle purchase. Remember with buying straddles or strangles, you want to see inexpensive options and expect a large move in the underlying. These two criteria foster a greater likelihood of a successful trade. Let's run the numbers.

Long Sep 15 call $.57
Long Sep 14 put $.38
Net Debit $.95

[Source: EduTrader]

Assuming you held the strangle until September expiration, you'd need to see at least an 8% increase or 11% decrease in the stock price just to break even. With the dampened reactions to earnings announcement we've seen so far this earnings season, long strangles have been a rare winner. A fact that I'm sure doesn't instill confidence in those willing to go out on a limb and buy strangles.

So what about the straight call purchase? Well, purchasing one side of the strangle certainly makes the trade cheaper, which decreases the amount of risk. It also lowers the breakeven so Dell doesn't have to rise as much to profit. I've never really been fond of directional bets into earnings as I don't really think anyone has much of an edge making that bet. It's more of a coin flip in my opinion. But I suppose if you have a bullish bias, the long call would trump the strangle.

As for myself, I don't tend to play cheaper stocks like Dell as much and not sure I see much of an edge either way into earnings. So I'll be sitting this one out.

Follow me on Twitter

Tuesday, August 25, 2009

The Tale of Two Tails

I don't tend to put too much faith in candlestick analysis as I've experienced numerous occurrences where supposed bullish or bearish candlestick patterns haven't followed through. Not to say candles aren't useful, because I think they are. I just wouldn't necessarily trade off of them alone. With that caveat in mind, the last two days have produced some rather bearish candles on the S&P 500 Index.

[Source: EduTrader]

As you can see we've got a pair of topping tails showing intraday reversals that have occurred two days in a row. These intraday reversals are showing a lack of strength from the bulls and an inability to maintain their early morning gains.

The catch 22 here is despite the candlestick weakness- every time the bears seemed to of gained the upper hand since July they've been rebuffed by the bulls rather quickly.

Nonetheless the last two days are assuredly not instilling any confidence in bullish traders and I wouldn't be surprised to see some follow through to the downside.

Strangling Gold

So the strangles I mentioned in GLD yesterday .... let's take look starting with rationale underlying selling strangles. In searching for candidates I'm primarily looking for one of two things:

1. a stock that's relatively range bound.
2. a stock with potentially overpriced options.

Frequent visitors to the blog can probably deduce that I tend to put more emphasis on number two (I doubt I would sell strangles on a name with options appearing underpriced) but if both criteria are met it's obviously better.

So how does GLD stack up?

It certainly has been range bound between $98 and $86 in all of 2009, so that takes care of criteria number one. As to the overpricing, take a look at the volatility chart:

[Source: IVolatility]

Current 30 day HV resides at 14%, with IV sitting higher at 18%. So we've definitely got the premium of IV vs. HV. Furthermore, like the VIX, GLD options have overpriced realized volatility consistently through all of 2009. Now, I'll admit this certainly won't happen indefinitely, but I'd rather bet with the current status quo rather than against it.

Sell Oct 103 call for $.90
Sell Oct 86 put for $.60
Net Credit = $1.50

[Source: EduTrader]

As GLD has treaded water since trade inception, the short strangle is currently profitable. The calls are up $.40, puts are up $.05. I'll buy them back ASAP at around $.20 or less apiece.

Monday, August 24, 2009

The Golden Triangle

Gold currently finds itself in the midst of a pretty clean symmetrical triangle. Being that it's seven months in the making it's also a pretty big one as well. As we're approaching the apex of the triangle one would assume GLD will make up it's mind as to which way it's going to pop sometime in the next few weeks.

For those with a background void of technical analysis, or perhaps those of you who studied in the easier top online MBA programs or similar business programs, let's expound on the structure of the symmetrical triangle.

A symmetrical triangle is considered a neutral price pattern consisting of consecutive higher pivot lows and lower pivot highs. Typically higher pivot lows denote bulls stepping in to buy the dips, while lower pivot highs imply bears selling every rally. The triangle is deemed neutral as neither group of market participants has the upper hand. As the apex looms closer and closer, one group usually begins to dominate thereby causing the stock to breakout of the triangle. Take a look see at the price chart of GLD below (click to enlarge).

[Source: EduTrader]

Notice the imploding 30 day HV showing the compression in volatility experienced as the triangle approaches the apex. The diminishing volume is also worth noting, as it's a classic sign of consolidation.

Since GLD has been dead in the water the last few months, I'm currently in a short Sept. strangle. I'll explore that tomorrow.

Options Action- NSC Covered Call

The VIX got some face time on Friday night's Options Action. The options crew pontificated on the current state of the VIX- namely its blatant overpricing vs. the realized vol of the SPX. With no major economic announcements or news to speak of on the horizon, the consensus was we could continue to see implied volatility getting sucked out of the market as it comes closer in line with realized vol.

So how to play it?

Finding overpriced options and selling them was the overriding tone for most of the show. And I tend to agree. It's worked for the last few months and will continue to work....

... until it doesn't!

So one of the names they mentioned with "supposed" overpriced options was Norfolk Southern (NSC). For those long the stock they suggested selling the September 50 call for $.85 to take advantage of the "juiced up" options. I agree with the general idea to sell calls on profitable existing stock positions as a yield enhancement tool, but I'll have to disagree that NSC options are pumped up enough to make it a stand out candidate for selling covered calls. Take a gander at the implied vol chart below:

While 30 day HV currently sits around 40%, IV is actually lower sitting at a mere 37%. So, in a market backdrop where it's actually hard to find options implied vol less than recent realized vol, they pick NSC as a prime candidate for selling covered calls? Not sure I follow on that line of logic.

Although I will say if you're long NSC, expect it to stagnate for the next month, and insist on holding the stock, selling a covered call may be better than doing nothing.

Friday, August 21, 2009

Back in the Saddle

Hey all. I'm back in the saddle from my hiatus with the good ole relatives from the Crossroads of America. While it was good to have some down time from the market, I must admit it's good to be back.

As I caught back up with my reading I found a few gems in the blogosphere worth a look if you missed em:

Bill Luby at VIXand MORE did a superb job in summing up the perpetual overpricing we've seen in the VIX vs. realized volatility over the past 6 months. Take a look at his post: The Gap Between the VIX and Realized Volatility.

For those seeking to get long volatility via the VIX or SPX, thus far it seems as if shorting puts on the VIX has worked better than most alternatives - long VIX calls or call spreads, long VXX, long VIX futures, long straddles/strangles on SPX, etc...

With August VIX options settling at 28.76, shorting the Aug 25 puts worked like a charm this go around. For an insightful take on VIX settlement take a look at Adam Warner's VIX Settlement Shenaigans over at DailyOptionsReport

Current 30 day HV on SPX is sitting at 17%, the spot VIX is around 25%, and Sept. VIX Futures at 27.35. The uptick in realized volatility as predicted by VIX and VIX futures has yet to materialize. Will we finally see it in the September cycle?

If I had to play VIX options for September I'd probably look at selling Sept. 25 puts sometime in the next week or so. With the way the VIX is priced right now, put sellers don't really have much choice in terms of strike prices. 25 is about the only one with enough juice to consider playing.

On a side note I like the higher probability inherent with selling the OTM put (particularly on a mean reverting underlying such as the VIX) vs. making a speculative play by buying OTM calls.

Thursday, August 13, 2009

R & R

My posts have been somewhat scarce as of late as I've been swamped prepping for a bit of R&R. Just wanted to give you all a heads up I'll be out of town for the next week, so I'm not sure if I'll be posting much.

The wife and I are off to visit some family in Indiana.

Best of luck on your trades-

Tuesday, August 11, 2009

Signs of Weakness.... Egads!

We're finally starting to see a few chinks in the armor. At the risk of reading too much into some morning weakness (as most know, morning weakness has been met with afternoon strength like a gazillion times over the past month), I'm going to highlight a few charts illustrating some major fib levels we've run into that may be the cause for the pause in the markets. I for one think a retracement would be just what the doctor ordered for this extremely overbought market.

Although the Nasdaq 100 (NDX) has been a market leader, its run-in with the 50% retracement level has certainly provided some headwind for this tech laden index. It may just have a date with it's 20 day MA today or tomorrow.

[Source: EduTrader]

The S&P 500 Index (SPX) has lagged the NDX and just recently tested its 38.2% retracement level. We'll see how far today's weakness takes us, but it would certainly be nice to see a drop towards the 970-980 area.
[Source: EduTrader]

Tomorrow's Fed Announcement (2:15 PM EST), should provide a bit of a catalyst to fuel a market move one way or the other. Let's hope market participants use it as an excuse to continue the selling.

Wednesday, August 5, 2009

A Double Diag on Mr. Softee

After disappointing on earnings and gapping down about 8%, MSFT is left in an interesting predicament.

Despite the earnings debacle, MSFT still remains above it's 50 day MA. The chart looks to be somewhat neutral (click to enlarge).

Implied Vol seems cheap on two fronts. First, after getting smacked post earnings, IV is now sitting at 52 weeks lows (28%). Second, with 30 day HV residing at 37% and 10 day HV at 50%, IV is low compared to recent realized vol. With the post earnings gap, HV is obviously skewed upward a bit. 10 day HV should drop considerably once the gap (9 days ago) is taken out of the equation (which should be in two days). Gap or no gap, IV still seems fairly cheap.

[Source: IVolatility]

So.. what to do???

While there are certainly a myriad of methods available for getting long volatility (i.e. straddles, calendars, diagonals, long calls or puts, etc...), one would want to take into account their outlook on the stock before choosing. Sticking with our neutral outlook let's walk through a double diagonal trade.

Why a doub diag you ask?
Well the only other neutral, long vol trade we could have chosen was a single calendar or diag spread. Although more expensive, the double diag widens the profit zone, thereby increasing ones probability of profit.

Double Diagonal:

Put Diag: Long Oct 22 put for $55, Short Aug 23 put for $22
Call Diag: Long Oct 26 call for $45, Short Aug 25 call for $20
Net Debit = $58

The risk graph shows that the profit zone lies between $22.60 and $25.40.

Now, you could reduce the cost of the trade by buying Sep options instead of Oct. However buying Oct. gives the ability to do a calendar for both Aug and Sep options. You could also change the strikes involved.

If you're still somewhat fuzzy on why a double diagonal is a long volatility play check out Vega Part I and Vega Part II

Tuesday, August 4, 2009

The Seemingly Endless Volatility Implosion

I gotta tell ya if this market gets any more volatile I may just have a heart attack...

Today was like watching paint dry.

Where are the good old days when the market used to actually move up AND down. Funny thing is there are probably investors that absolutely love this market strength... Unfortunately, I find it rather boring and difficult to game. Dip buyers are still waiting and those late to the party charlies who jumped in after the market was already up 10 + days now seem like geniuses.

With today's shnoozer, 30 day HV on the S&P 500 is now sub 20 (19%). It's more sensitive counterpart, 10 day HV, has imploded as well to a measly 13%. I keep an eye on 10 day HV to garner a better reflection of what's going on right here right now (click to enlarge).

[Source: EduTrader]

It will be interesting to see when we finally get an uptick in volatility. As far as when that comes, I have no idea.

One thing is for sure, anyone trying to bottom pick volatility has just been reminded of the futility of bottom fishing.

Saturday, August 1, 2009

Options Action - PG Earnings

Friday's Options Action included a preview of the upcoming earnings on Proctor and Gamble. PG, the 4th largest weighted company in the S&P 500 Index and big dog within the consumer staples sector, reports earnings this Wednesday August 5th (not sure if it's pre or post market). Let's take a gander at its volatility characteristics then break down two different strategies thrown out by the Options Action pundits.

A chart review of the reaction to the last 3 earnings announcement shows that PG hasn't moved that much after recent announcements (click to enlarge).

[Source: EduTrader]

Not surprisingly, realized vol on PG has been imploding over the last few months. For you adrenaline junkies out there, PG probably isn't on your radar as it isn't really a mover and a shaker. Current 30 day HV sits at 18%, 10 day HV around 13%. As is usually the case, with Implied vol around 25%, the options board is pricing in an uptick in volatility going into the earnings announcement.

[Source: IVolatility]

Despite the current premium of IV over HV, the two strategies highlighted on options action were both long volatility trades. One pundit mentioned that he usually looks to sell volatility going into a catalyst because options are generally overpriced (I agree). However, he then asserted that, "premium in this name is incredibly cheap already." Now let's put the word "cheap" into context. We've already illustrated that IV is not cheap relative to recent realized vol (e.g. 30 or 10 day HV). Matter of fact it seems on the expensive side. However it is fair to say that due to IV imploding over the last 6 months it is cheap relative to where it has been over the last year or so.

Which is the better comparison?

Hard to say, but I tend to put more emphasis on comparing IV to what's going on right here right now. So I'd say PG options aren't really "increadibly cheap" when seen with the recent market volatility backdrop. Consequently, I'm not convince that options are a slam dunk buy here.
Let's delve into the details:

Calendar Spread:
Buy September 57.50 call for $1.00 and simultaneously sell an Aug 57.50 call option for $.50.
Net Debit = $.50
[Source: EduTrader]

As you can see, the profit zone ranges between about $55.50 and $60. From a directional standpoint the calendar spread is a neutral to bullish bet.

The next recommendation was to enter a long Aug strangle by purchasing the 55 put for $1.15 and 57.50 call for $.50.
Net Debit = $1.65
[Source: EduTrader]

The profit/loss zone is almost the inverse of the calendar spread. At expiration PG has to either be above $59.15 or below $53.35.

Both trades are long Vega, meaning that they profit from a rise in implied volatility. This is quite intuitive as both pundits agreed that PG options seemed on the cheap side. The one big difference between the two trades is the strangle is a long gamma/negative theta trade and the calendar is a short gamma/positive theta trade. If you're expecting a huge move out of PG earnings and want to get long gamma, well I'd take the strangle. If on the other hand you don't anticipate a large move and are looking for PG to drift sideways to up into Aug expiration, I'd take the calendar.

For more info on the relationship between gamma and theta, take a look at Clash of the Greeks Part I and Part II.