How I like to structure a bearish trade based on the Greeks

Posted by: Admin: "The Vol_Trader"  //  Category: Trade strategy

Today I’ll tell you about a trade I often do on equities that I’m bearish on.

First, I scan for bearish chart patterns.  Once I find one I look at the skew curve.  I like to see a relatively flat vertical skew for at the money strikes.  (Vertical skew is the skew from strike to strike in the same month).  For this trade I’m not trading skew but rather direction and I’m going to take advantage of the skew that forms when my underlying moves down pushing up OTM put IV. (Skew chart below from LiveVol Pro) (Click any picture to enlarge)

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As you know, when the underlying goes down the IV of the puts is driven up as the longs buy puts for protection and the speculators buy puts to speculate.  As the underlying goes up, the IV is driven down when the longs sell their protective puts.

With this knowledge it makes sense to put on a trade this is long Vega to the downside and short Vega to the upside.  This can be accomplished by selling a combo.  Long put, short call.  The plot of Vega is a beautiful sight, see below plot of Vega (Y-Axis) vs. Underlying price (X-Axis).  

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The only problem is you have unlimited upside risk.  See below P&L chart of short combo.

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So, I have identified risk to the upside.  I want to hedge this trade but keep my advantageous Vega profile.  I could add long calls to protect the upside but that will make me much more long vega which is not what I want to be if the underlying moves up. 

We could use a bullish call vertical spread to hedge the upside some.  We’re all taught that vertical spreads are vega neutral.  However, the more you widen the strikes the move Vega you get because the options closer to the money have a larger vega than the farther OTM.

In my example I’m going to look at an OTM call vertical which looks like the below plot of P&L and Vega respectively:

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So, by adding this call vertical I hedge some (not all ) of my upside losses and maintain my very favorable Vega structure.

Here’s the trade:

Underlying is LFC $58.55 (China Life Insurance Co Ltd) which is in a downtrend since it peaked in Dec 2009.  See the two year daily chart below.  (In my opinion) It has broken out of a trading range dating back to Apr to the downside.  There’s a gap down to the $55 level.  This is a beautiful chart example of what happens when there’s a gap, even a long time ago.  Look at the lack of volume from $59 to $62 and how fast it fell through this range.

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Short combo: –20 Oct $60 calls / +20 Oct $57.50 puts for debit of $0.20

Long Vertical: +10 Oct $57.50 calls, –10 Oct 62.50 calls for a debit of $2.10

The combined trade P&L looks like this:

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You could modify this by buying the long call vertical with 20 contracts instead of 10 to get a better upside hedge but it also reduces downside profit a little.  That looks like this:

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The plot of Vega (Y-Axis) vs. Underlying price (X-Axis):

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Exit Strategy:

On the downside, I’m comfortable with the underlying moving up to around the $62-$63 range.  At current IV and today, this equates to a loss of around $4,400 but we know that as time goes on and IV drops I will have a smaller loss.  On the downside I’ll look to take some profit one spread at a time as the underlying moves down.  Vega will be working in our favor and theta will be working against us.  The nice thing is that Theta is not that great of a factor.  You can see in the below plot of theta at 14 day intervals that theta is very small in the beginning and then gets more and more as we get closer to expiration.

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I’ll post updates as this trade progresses.

*Education purpose only, not a trade recommendation!

Short naked put vs. short put vertical spread, open for discussion.

Posted by: Admin: "The Vol_Trader"  //  Category: Trade strategy

Today, I’m going to try a new format. 

I received an email from a reader that I wrote a relatively quick response to. 

What I am going to do/try is to post his question here and my response and open the comments up to discussion.  Please participate….  – Lawrence

PS: I’ll post a continuation to the OTEX (losing) earnings trade later too…

Note: the reader’s name has been changed for privacy, it was not Elwood Blues writing…

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08/23/2010 Elwood Blues sent in via email:

Hi there,

I am trading mainly stock options and usually short sell out-of-the-money puts. The strategy is doing fine, but I am currently thinking about my risk management:

- Usually I follow the double out rule (i. e. as soon as an option reaches the double premium I got for it, I close it to limit my losses). But this rule kills you in a volatility spike – you are stopped out, even if the stock is still far out of the money, sometimes even moving in the correct direction.

- A friend of mine advised me to look only at the intrinsic value. This of course protects me from being caught in volatility spikes, but the losses are much higher.

Do you have any good idea?

Best regards,

Elwood

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8/23/2010 Lawrence “VolTrader” wrote via email:

Hi Elwood, to answer your question completely would require a pretty long options education, rather than just an answer but I will do my best to give you a simple explanation…

You are right when the underlying moves against you the vol spike will increase losses.  This works in your favor as the market goes up, vol goes down and your short put benefits, a double edged sword.

A simple fix to this is to sell a put spread instead of a naked put.  This means sell your OTM put and buy a further OTM put as protection.  This limits your losses, reduces your margin requirement and protects against vol spikes.  As your short put gains in value due to the underlying going down (delta effect) and gains in value due to vol increase (vega effect) your long further OTM put also gains in value due to delta and vega…  Also, because these are limited risk (not unlimited like short naked put) you can hold them longer and see if your underlying moves back in the favorable direction and allow time decay (theta effect) to work in your favor as both options lose value over time, the closer to the money short put faster.

Elwood, can I post this conversation to my blog and open it up to discussion through comments?  (I’ll just put a fake name for you)

Lawrence

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08/23/2010 Elwood Blues sent in via email:

Thanks a lot for your quick reply! I thought about this strategy as well – the minus is only that it will also limit my possible profits…

Sure you can put it to the blog!

Regards,

Elwood

DIS – an update after earnings announcement

Posted by: Admin: "The Vol_Trader"  //  Category: Earnings Trades, Trade strategy

So, last night at the close DIS reported earnings.  Initially AH the stock was up but as of right now, DIS is trading down 2.75% at $34.32

As you can see from my previous post (Click here) I was looking for a big move up or down to profit from this trade. 

We didn’t get the move I was looking for, however, I’m about breaking even and actually up a few bucks (enough to cover commissions at least).  Why did this trade work even if the underlying did not make the desired move?  (Rhetorical question).  My prediction of IV was correct.  August lost mostly all of its extrinsic value and Sep did not. 

You can see in the LiveVol Pro skew tab below how the Aug IV (red line) dropped back down to the same level as the back months. (click any picture to enlarge)

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Below is the Thinkorswim analyze tab at the current price:

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You can see the current P&L (white line) is almost all above the breakeven line due to the IV drop. 

At this point I’m thinking of exiting all or half at breakeven.  With less than an hour to trade today, I’m going to watch for a late day sell off.  I’ll likely exit if we get it or not.

I’ll keep you posted.  Thanks for reading! Lawrence

An update on MCK earnings trade – trade management, exit strategy.

Posted by: Admin: "The Vol_Trader"  //  Category: Earnings Trades, Trade strategy

As I last posted (click here) on MCK the day after reporting when I closed three 3:2 spreads for $1.00 debit after initially getting a credit of $2.37 when putting them on.

I said that I was in no rush to take off the remaining spreads as they had become positive theta when the underlying moved down.

I’ve been patiently holding them with orders open to take off small positions at a time.  With time passing and MCK down a bit more, so far today two more 3:2 spreads have executed and closed for debits of $0.78 and $0.62. 

I still have four spreads open with orders to get out of them at $0.45 and $0.36.  I may move those orders up and get out of this trade by the end of the day today.  So far profit on this trade is $1768 including both open and closed positions.

The remaining contracts look like the Thinkorswim analyze tab below. As you can see there’s little profit potential left so I’ll look to be out by day’s end today. (click any picture to enlarge)

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DIS – how I pick and setup an earnings trade

Posted by: Admin: "The Vol_Trader"  //  Category: Earnings Trades, Trade strategy

Yesterday, just before the close, I put on a trade in DIS.  They are set to report earnings today after market close. I put on a ratio diagonal spread.  I am going to walk you through my thought logic in picking this trade.

My first stop is the Live Vol Pro (www.livevol.com) software Calendar tab. I look at all the earnings for the desired date.  I then pick liquid names that are usually trading above $25 per share.  (click any picture to enlarge)

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Then I look at these symbols in the Skew tab looking for horizontal and vertical skew. 

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Next, I move to the Charts tab and look at the six month plot of 30 and 60 day implied volatility.

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And finally, I look at the previous earnings periods moves and responses of IV and the prices of the front and back month straddles in the “Earnings and Divis” tab to get a feel for how this underlying responds to earnings historically.

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In the case of DIS I see that there are both horizontal and vertical skew.  I see that both 30 and 60 day IV are not that elevated compared to previous six months IV and especially not high compared to historic earnings announcements.

Putting all this together I will then pick which trade to put on.  I almost always use term structure when trading earnings, selling high IV near term options and hedging with back month options.  When you trade calendars and diagonals one of your big risks is IV collapse of your long options along with your short options.  In this case, I don’t see much Vol crush happening to my long back month options as they are low relative to historic IV.  With only 11 days remaining in the front month Aug options, they will experience some Vol crush as IV goes to zero at expiration.

So, at this point I look at the skew tab and get an idea of where I want to be short and long.  I want to sell overpriced lower strike Aug options and buy higher strike Sep options taking advantage of Horizontal (month to month) skew and Vertical (strike to strike) skew. 

In this case I changed my strategy slightly by buying a higher strike than I sold but I am  still buying lower IV than selling. I put on half of a position yesterday and will put on the other half today.  If the underlying moves in the desired direction I’m happy as I have a small win already, and if the underlying moves in the opposite direction, I’m happy as I get a better fill price for my second half.  It’s a win-win situation, rare in trading.  Here’s the trade:

(Half position) Long twenty Sep $35 puts, Short ten Aug $38 puts for  a credit of $0.56 per 1:2 spread.

The P&L chart looks like this:

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As you can see, I’m looking for a significant move in DIS, preferably to the downside.  Historically DIS gaps after earnings enough to move past my breakeven points, especially when it’s to the downside which is where my biggest profits will come.  Using the Thinkorswim analyze tab I model this with dropping the Aug IV by 5% and Sep by 2%.  This puts my breakeven points $33.78 and $36.20. Dis closed at $35.16 so there’s not that much of move needed.  This is a defined risk trade.  My max loss would never occur because I’m not going to hold my Sep options until they expire, but the max loss would be around $2,400 if the Sep options IV went to zero which will never happen.  With my above prediction of IV the max loss, if Dis moves nowhere, is around $300-$500.

Double these numbers for when I put on the remaining half today.

Plotting the breakeven points against the daily chart in Thinkorswim looks like this:

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Exit strategy: Since this is a defined low risk trade I’m not in any hurry to get out, but it is a negative theta trade so time is working against me.  If there is a gap opening I’ll take my profit of at least half the position immediately and then watch the remaining for a big move in Dis after earnings. 

As always, I’ll keep you posted.

Comments are encouraged and appreciated.  Thanks for reading!  Lawrence