An earnings trade MCK

I’d like to present an earnings trade today.  I’ve been so busy with my regular job as a Podiatrist that I have not had time to write (or trade). 

I found MCK in the LiveVol Pro software (www.livevol.com).  LiveVol has a nice calendar of earnings and dividends.  One click on the symbol brings the underlying up to all the tabs where you can then assess the skew, read the news, see the fundamentals, chart the underlying, chart the many volatilities, see the historic volatilities as a response to earnings, see the options chains, see all the options trades and so many magnificent things that help to trade options.  (Okay, infomercial is over.  I just love this software so much that I will give them free plugs whenever I can.  My secret agenda: I just want them to have lots of clients so they stay solvent and never go away.  Oh, and with the same motivation in mind, trade at www.thinkorswim.com.  Thanks!)

So, MCK, as always, I want to buy low Vol and sell high Vol. With earning coming before the open on 7/30/2010, the August IV is elevated compared to back months options.  Looking at the LiveVol Pro software, historically, the near options lose IV much greater than the back month after earnings as you would expect them to.  The front month straddle loses value about half the time and gains about half the time.  This means I don’t want to simply sell front month straddles with only a fifty percent chance of success.  See below (click any picture to enlarge) : (What to look at: The bottom set of lines is the IV of the front and back month options. Red front month, blue back month.  The red collapses more than the blue after the earnings ‘E’ symbol)

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I want to sell high Aug volatility and buy lower Sep volatility. Using the LiveVol skew tab below you can see the Horizontal (Aug higher than Sep) and Vertical (steep line with lower strikes having much higher IV) skew exists.  So, I want to sell high Vol Aug lower strikes and buy lower Vol higher strikes. 

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The trade: buy 30 Sep $67.50 call, sell 20 Aug $62.50 call for a net credit of $2.68.  MCK closed last night at $64.02.

Trade logic.  First, by looking at the LiveVol 3 month chart of IV30 vs. IV60 (See below),  I make an estimate on future IV of Sep and Aug.  My conservative estimate is after earnings Aug will drop by 6% and Sep will drop by 2%.  I put these numbers into my Thinkorswim analyze tab by clicking on the wrench and then ‘more’ which allows me to change the IV of Aug and Sep separately (picture below). 

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The Thinkorswim analyze tab looks like this now and at Aug expiration:

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Before adjusting for IV changes, I’m risking around $800 if MCK moves up to around $69 to make $2300 on the downside.  When I adjust Aug and Sep IV –6% &-2% respectively, my risk reward is around $1000 : $2300.

Exit strategy:  If MCK moves up to $68 I will get out and take my losses.  If it moves above $68 I’ll most likely still get out but if there’s a monster rally, I may hold as I have upside profit potential.  If it moves down, I’ll start taking off 3/2 spreads one by one taking profit.  As usual, if it moves down I will not be in any rush to take off spreads as theta will be working in my favor. 

Again, sorry for my absence lately.  I will update this trade as it plays out.

Thanks for reading, Lawrence

PS: if you’re live in NYC and need a good podiatrist click here:

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