Thursday, April 29, 2010

Time to Shine?

With Tuesday's free fall in equities came a rush into the supposed safety zone of gold. After lying dormant for five months, gold is knocking on the door of a potential breakout. Since December 2009, gold has found a home within the $100 point range between 1060 and 1160. Will this base serve as a launching pad for a breakout and resumption of its longer term uptrend? To further support this premise, those with a knack for chart reading may also be noticing the multi-month inverse head and shoulders pattern that is on the cusp of completion.

[Source: MachTrader]

How about considering selling a put spread on the SPDR Gold Shares (GLD) to take advantage of a continued rise in gold? With a mere three weeks remaining in the May expiration cycle there isn't much extrinsic value remaining. As such, I'd probably opt to use June options in constructing the put spread. Suppose we sell the June 110 put for $1.40 and buy the June 105 put for $.50. As long as GLD remains above $110 by June expiration, we're looking at a maximum reward of $90.

As is the nature of all OTM put spread, we have a relatively high probability of profit but a smaller risk/reward ratio. That said, a $90 return on $410 is still over a 20% return.

For related posts, readers can check out:
Previous GLD Posts
Bull Put Spreads

Wednesday, April 28, 2010

Volatility Spike and Ratio Spreads

Yesterday's monster sell off ushered in a notable resurgence in fear. With a 30+% spike in the VIX, there certainly seemed to be a mad dash toward buying option premium. The 64K question is whether or not this upturn in volatility is a "one hit wonder" soon to subside, or whether it's a clarion call to the bears to come out from hibernation and start wreaking havoc on the market. No doubt time will tell which scenario ends up playing out. It will be interesting to see over the remainder of the week whether or not we get some significant follow through to the downside.

Provided Tuesday's sell off is a short lived event, the volatility ramp up is certainly providing some compelling opportunities. In Volatility Skew and Ratio Spreads I explored volatility skew and how to use ratio spreads to take advantage of potentially overpriced downside puts. Let's take a renewed look at the vol skew that has elevated over the last few days and construct a potential ratio spread.

A quick assessment of the SPY option chain shows lower strike puts trading at higher implied volatility levels than higher strike puts. From a volatility perspective we prefer to buy options trading at lower volatility levels and sell those trading at higher volatility levels.
We may consider structuring a ratio spread to exploit the relatively expensive OTM puts. Suppose we purchase a May 117 put for $150 and simultaneously short three May 113 puts for $240 ($80 x 3). Consider the risk graph below:

[Source: MachTrader]

The blue, red, and green lines display the affect of declining volatility. The upward shift shows the positive effect this could have on the trade. When entering a ratio spread, traders can modify the risk-reward by changing the ratio of long to short options. While some trader may opt to do a 1 x 2 spread, others may prefer a 1 x 3 spread. At the end of the day you need to assess the risk graph to ensure your comfortable with the potential risk inherent to the trade. While shorting 3 puts for every 1 you purchase offers a higher net credit, it also possesses more downside risk due to the additional short puts.

For related posts, readers can check out:
Larry McMillan on Volatility
Volatility Skew and SPY Ratio Spread Update
Gaming the Sell-off with Put Ratio Spreads

Monday, April 26, 2010

Betting on Casinos

Amidst the market tear and bear boot stompin', one area exhibiting recent relative strength versus the broader markets is the gaming and casino industry. The likes of MGM, LVS, and WYNN are up from 15-30% over the last month alone. While I can't speak much to the fundamentals of these high rollers, it's tough not to like their recent price action (click image to enlarge).

The Options Action gang concocted a bullish option strategy to exploit a continued rise in MGM stock. The play consisted of a short Jun 15 put and a long Jun 17.5- 20 call spread. After buying the call spread for $60 and receiving $110 for the short put, the trader would be left with $50 credit at trade inception.

That $50 represents the minimum profit potential if MGM remains above $15 by Jun expiration. The ideal scenario is for MGM to rise above $17.50 so the call spread will start to move in-the-money. The maximum profit zone comes into play over $20 at expiration.

[Source: MachTrader]

One variation to the suggested trade worth considering is simply selling the naked put and avoiding the call spread. Though the call spread increases your delta exposure and grants larger profits if MGM rises above $17.50 by expiration, it does reduce the overall net credit received. At the end of the day, there are numerous ways traders can construct bullish option positions. The key is to ensure one is comfortable with the risk-reward and pay off structure.

For related posts readers can check out:
Options Action
Delicious AAPL
Bull Call Spreads

Thursday, April 22, 2010

Decision Trees

At some point during a trader's learning curve they will undoubtedly be introduced to the idea of developing a trading plan. Achieving consistent results necessitates having a consistent approach. It is quite unrealistic to expect consistent returns month to month if you lack structure in your approach. While shooting from the hip or "winging it" may require less effort, it is usually a recipe for disaster in the long run. Each trader should have some type of method to the madness, a rhyme and reason as to their timing, trade, and risk management. A systematic approach has helped me in producing more consistent results.

While there are numerous ways to explain one's trading plan and outline the decision making process, one tool of worth I've found particularly useful with adjustment trading is a decision tree, such as the one displayed below:

Decision trees offer the ability to model potential trade adjustments based on changes in the underlying market. In the tree highlighted above I've displayed the Sling Shot trade mentioned in Tuesday's post with various adjustments worth considering. T1 represents the original trade, while T2 and T3 represent secondary and tertiary adjustments. The beauty of the decision tree lies in its flexibility, as it allows users the ability to create very simple or largely complex models.

I've also found them quite useful from an educational standpoint. It's proved much simpler to show the potential adjustments traders may make at various points in a trade as opposed to explaining them.

Tuesday, April 20, 2010

The Sling Shot

Recently I've been playing around with a directional strategy, informally dubbed the "sling shot", that I was introduced to by one of my trading colleagues. It's a neat little strategy which incorporates some of the adjustment techniques introduced in Adjustment Thinking and the Salvation Syndrome as well as Adjusting in Action: Long Call to Call Spreads and can be used for those with a knack for forecasting price direction. In an attempt to exploit the bullish retracement in oil last week (as highlighted in Crude Retracement), I entered a sling shot on the United States Oil Fund (USO).

The structure of the trade involves simultaneously purchasing shares of stock and OTM call(s). Typically you unload the shares after achieving a 1 ATR profit. Ideally this 1 ATR profit pays for most, if not all, of the cost of the call options. In other words, we're using the profit from the stock portion of the trade to finance the purchase of the call options. Upon selling the shares of stock you could either remain long the calls or roll them into a spread to further reduce your risk. Let's take a look at the play in action using USO.
On April 13th, I purchase 100 shares of stock for $40.70 and 2 May 43 calls for $.55 apiece (click image to enlarge).
After rising around $1 (a little over 1 ATR) over the next day and a half, I sold the stock for a $100 profit. This $100 profit paid for all but $10 of the cost of the long 43 call options, which took the risk from virtually unlimited (due to the long stock) down to $10. Though I didn't lock in any gains, the adjustment succeeded in lowering the overall position cost and reducing risk.
If I was aggressively bullish on USO I could have simply remained in the long call options. However, given that I wasn't that bullish I instead opted to roll the long calls into a call spread by selling the May 45 call options for $.40 apiece. By receiving an additional $40 of premium, My $10 of risk remaining in the trade turned into a minimum reward of $30. This time the adjustment did lock in gains.
[Source: MachTrader]

Though USO has since dropped back in price resulting in giving back some of the unrealized gains, my original risk capital has been taken off the table. The crux of the trade as I see it is getting the first ATR move in your favor. Once you've locked in the profit on the stock, the risk-reward payoff as outlined in the risk graph improves dramatically. Going forward I'll periodically come back to the sling shot to shed further insight.

Friday, April 16, 2010

Covered Calls and the Oracle of Omaha

Let's pop open the mailbag and tackle some viewer mail.

I bought 100 shares of BRK-B at $71 shortly after it split. I've been thinking about covered calls on the stock. I plan to hold it for several months and figured maybe I could sell the calls in the meantime. I expect the stock to stay pretty flat for a while, so doesn't it make a good candidate? Karen-
Hey Karen,

Evaluating covered call candidates is a two part process. Since they perform best in neutral to mildly bullish markets, I would first find a stock that fit that description. However, not all stagnant to mildly bullish trending stocks are going to work for covered calls. The second part of the process involves assessing the options chain to determine if there is a strike price that will provide sufficient premium to make the trade worthwhile. There are a couple problems that may crop up when trying to find the right option to sell. First, the strikes may be too far apart, which means you'll either have to sell a call option that is ITM (which cuts off any appreciation in the stock price) or one that is too far OTM (which may offer little premium).

The second issue that may arise is that of volatility. If the implied volatility of the options you're considering selling is too low, there may not be enough premium to make it worth your while. With this process in mind, let's take a stab at BRK-B (click to enlarge).
[Source: MachTrader]

You'll have to be the judge on whether or not the chart is neutral to mildly bullish. I'd say it looks more neutral, though it has rolled over a bit in the last month. Take note of the historical volatility displayed at the bottom of the chart. At 9%, BRK-B is definitely not a mover and a shaker (the post split ramp being the exception of course). As a result the options trade at pretty low implied volatility levels and therefore offer little premium when compared to the $80 you're shelling out to buy shares of stock.

One final issue worth mentioning is the availability of strikes. Due to its high share price, BRK.B only offers strikes every $5 apart. Given its low volatility a $5 move is quite large. Consequently, the OTM options don't offer much premium at all. In the May expiration cycle, the only strike in play is the 80 and it's only offering $1.50. The 85 strike is too far OTM and the 75 is too far ITM.

For related posts, readers are encouraged to check out:
Investigation of an Over-Write
Over-Writes: A Delta Perspective
Over-Writes: A Delta Perspective Take Two

Wednesday, April 14, 2010

RIMM Options on Sale?

Though S&P options remain overpriced versus realized volatility, there are a few spots where implied volatility has come in enough to make buying options somewhat attractive. One such candidate is RIMM. Following its earnings announcement about two weeks ago, implied vol has dropped precipitously to around 30%. In finding evidence that options are cheap we could point out that this is a 52 week low in implied volatility, but truth is that's not saying much. Just about all options these days are seeing vol at 52 week lows. What is more noteworthy in RIMM's case is the fact that implied vol is right in-line or perhaps a tad low when compared to realized volatility.

Now to be fair, the earnings gap is still in the calculation of 20 day HV displayed below. As a result it's skewed higher than what it would be without the gap. However, excluding the gap, you're still looking at realized vol around 30% which is in-line with current option prices (click image to enlarge).
[Source: Livevol Pro]

Yet another sign that options are getting more attractive for buyers is the cyclical nature of RIMM volatility as seen over the past few earnings announcements. Usual within about a few weeks to a month following earnings, volatility has had a tendency to bottom.

Lest you think bottom fishing in volatility is a walk in the park, take a look at Adam Warner's write up regarding the fight between time decay and adequate price movement.

For related posts, readers are encouraged to check out:
The Tempest and Volatility Analysis
The Cycle of Implied Volatility

Tuesday, April 13, 2010

Crude Retracement

After oscillating between $70 and $83 a barrel for 6 months, crude oil finally broke out of its trading range two weeks ago. After rallying to $87, crude has since experienced an orderly retracement back to its breakout point. If you subscribe to the notion that prior resistance becomes new support, this may be an area worth watching closely for bullish entries. If oil plunges right back into its old trading range, the validity of last week's breakout will be brought into question.

[Source: MachTrader]

For non-futures traders, the United States Oil Fund (USO) is probably your best bet for a proxy of crude oil. In my experience it's done a well enough job in tracking crude oil to make it a viable trading vehicle.

Sunday, April 11, 2010

GOOG, I'm Feeling Lucky

Looks like last week's Options Action had a perky Brit named Simon pinch hitting for Melissa Lee. Though he started out like a car salesman amped up on too much caffeine, he fortunately mellowed out as the show progressed. With a slew of earnings on tap next week, they offered up a few trade ideas to mull over. Could earnings be the catalyst to finally propel the market out of its sleepy grind higher? I think it's a decent thesis. I mean, how much lower can historical volatility get? At 7%, it's certainly not tough to bet it will rise at some point. It's timing the turn that can be uber tough though. As most of us know, complacency can linger for quite a while.

As is typically the case, Google has earnings the day before options expiration. With only one day remaining in the front month options and such a big potential move in the works, you can bet the April options will be trading at high volatility levels. Though the large premiums in 1 day options can be quite alluring, keep in mind flirting with gamma can get you a black eye before you know what hit you. Rather than deal with the high risk high reward inherent with April options, Options Action suggested making a directional bet by buying the June 560 put and selling the June 510 put for $15. As of Monday morning, the put spread was actually trading around $13.5, so we'll use that for the risk graph.

[Source: MachTrader]

Typically I'm not a fan of playing strong directional plays into earnings, but if I was going to take a stab at it, I do like the idea of using a spread versus buying options outright. As long time readers know, volatility gets sucked out of option premiums pretty quick following earnings. Using a spread helps to mitigate some of this volatility risk. Also, keep in mind GOOG options have a wider bid/ask spread, making it even more important to use limit orders and get a good execution.

For related posts, readings can check out:
Bear Put Spreads
Options Action

Thursday, April 8, 2010

The Relativity of Volatility

Apologies for the sparse posting as of late. My time has been eaten up by other endeavors leaving little room for nurturing my little corner of the blogosphere. Rest assured this next week will be more interesting as I've been tinkering with a few posts in my workshop of ideas. So how about kicking it off with a few volatility musings...

When analyzing volatility remember that there aren't really any absolutes. Take the VIX for example. While it would be nice to assert that the VIX is "low" when at 20 (cheap options) or "high" when at 30 (expensive options), the truth is its all relative. The VIX could be at a crazy low level like 10 and options could still be overpriced. On the other hand it could be in the stratosphere at 80 and options could still be underpriced. Whether implied vol was too high or too low when you entered an option trade depends on the volatility of the underlying throughout the duration of the trade. Suppose you think SPY options are cheap right now so you buy an ATM straddle. Currently the implied vol on the May 119 straddle is around 14.5%, which implies a little less than a 1% daily move should occur approximately 68% of the time in the SPY. That's a lot of numbers so read that last sentence again if you need to. Even though 14.5% vol seems cheap, what if the SPY is only able to muster up a .5% move on average each day (which coincidentally is pretty much happening right now)? Well, sorry charlie but you overpaid for that straddle. Though you looked at a low absolute number like 14% and made the assessment that options were a buy, reality is they were still a sell.

One lesson I can draw from my experience selling condors back in 2006 and 2007 is the fact that options' volatility can continue to be expensive even with the VIX sitting at barn burning low levels like 10. Between Oct 2006 and Feb 2007 the VIX found a nice home right around 10; a level which historically speaking is very low. How much volatility did the SPY actually realizes over the same time frame? About 7%, which made selling condors a lucrative proposition (click image to enlarge).

[Source: MachTrader]

This perhaps reiterates why it's beneficial to use a short term historical volatility reading like 10 or 21 days when assessing whether options seem cheap or expensive. It keeps us grounded in reality and serves as a useful benchmark for gauging what's happening in the here and now. While looking at the VIX now compared to 2008 certainly makes it seem like options are a steal of a deal, comparing it to recent realized volatility paints a different picture altogether.