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

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