Volatility Trader Blog

There’s many articles written on how to “repair a broken stock” out there.  Click here for a good recent example from The Motley Fool.  They instruct you to buy one ITM call (one for each 100 shares you’re long), and sell 2 OTM calls.  The only problem with this strategy is that it still leaves you with lots of downside risk.  The above mentioned article states if the underlying goes down all options expire and you lost just your commissions, try again and unfortunately your underlying’s value has lost even more.

I like to protect myself a little more than that to the downside, even if I’m bullish (why else would I own the stock?).   The easiest way to protect a stock from downside risk is to buy a put.  Buying a put makes me short theta which I hate.  I feel there is only one thing that is guaranteed in the market, time will pass.  I want to be long Theta whenever possible.  So, how do I offset the cost of my put and get short theta?

First I want to make my predictions as to where the underlying will go. Second, and equally important, I predict what IV will do.

Looking at the daily and weekly charts (click any picture to enlarge) with volume profile, I’m predicting PCP will stay in a range with support at 102 and resistance at 120.  Earning are on 7/22/10 and historically, it has not made major moves after earnings.  Volatility has also been in a range for some time and historically, Vol drops but not much after earnings. 

Using the above predictions, I want to create a trade that profits if PCP stays in a range, and if Vol stays the same or drops.

Here’s the trade. 

• I own 100 shares of PCP, currently trading at $107.79. (My price is $121.40)
• +1 Sep $105 put.
• +4 Sep $120 call.
• -5 Sep $110 call.

The P&L looks like this for the long stock (obviously) below:

The P&L looks like this after I added the options, below: Notice that this trade is ‘profitable’ in the range that I anticipate.  If the underlying stays in the range as I predict, my trade that is currently around -$1,400 will be -$300.  Then in Sep, I can put on a similar trade again as long as my predictions have not changed.  I now have a limited risk trade that I can manage or stop out if PCP should rally hard.  Synthetically, you’ve created a broken wing butterfly (long stock and long put is long call +1 $105call / –5 $110 call / +4 $120 call).

Also, the Vega is pretty neutral.  At first glance at the chart of Vega it looks exactly the opposite of what you want.  It’s short Vega to the downside and Long Vega to the upside, however, with further examination, you’ll notice the largest value for Vega is +/- only $26.  See below:

As usual, I’ll keep you posted as to adjustments and management. 

* Here’s an idea for discussion based on the above.  You can use this strategy to put on a bearish synthetic broken wing butterfly and own shares of your favorite dividend paying stock.

*this is not a trade recommendation, education only.

Sorry for my absence lately.

After Jul expiration I wanted to update you on two trades, V (Visa) and ASML. 

V update:  This trade turned out to be a good example of my management and trade adjustments that I regularly do, and ended with a little good old fashioned luck…

As you know, this trade was placed on 5/21/10 with a bearish bias (Click here to see). 

Four days after I put the trade on, I took off 3 of the 10 contracts for a small profit.  Often, if the trade goes well right away, I’ll take off a small portion for a quick profit and let the rest go for additional profits.  In mid June V went up and I had an unrealized loss with Jun expiration approaching.  6/14/10 produced a nice down day and although I was still at an unrealized loss, I was able to take advantage of the down day to produce a favorable roll, buying back my short Jun options and selling up and out Jul options. (Click here to see roll) Immediately after this, V rallied and then dropped back.  On the drop back, I was about breaking even and I decided to let this trade continue expecting a further drop in V and the market in general.  I was wrong and the market and V had a strong rally into Jul expiration week. I like to roll my shorts by Tues prior to expiration.  I analyzed rolling my short Jul options out to Aug or up and out to Aug but nothing looked good to me.  At best I would have locked in a smaller loss than I currently had.  My two choices were to close for a loss or hold on a few more days hoping to get lucky with a drop into expiration as my trade was purely a directional gamma play now.  Normally I would not hold a trade and hope for a lucky ending but in this case I didn’t see much risk to the upside and my alternatives were not good as I described above.  Additionally, since I was able to take some profits on the first three contracts, I had a little bit of a buffer.  Well, I got my wish and expiration Friday turned out to be a great day.  Right at the open I took off five of the remaining seven contract spreads for a nice profit, and later in the day, I took off the remaining two spreads for an even larger profit.  In total, I ended up with a $1,442 profit. 

ASML update: I’ll jump the conclusion and then tell you how I got there.  As of Friday’s close I’m down $246 on this trade.  This is not bad considering that this trade is bearish and long Vega.  I put this trade on with ASML at $30.28.  Friday ASML closed at $30.92.  Clearly my short delta didn’t help this trade.  When I put on the trade I was long Vega and this trade remained long Vega throughout the whole time.  Implied volatility dropped from 42.38% when I placed the trade to 36.08% at Friday’s close.  So how did I (about) break even when delta and vega moved against me?  A few things helped.

• First and most important, SKEW.  Click here to see my initial post where I described putting on trades that have ‘a slight advantage based on volatility’ skew.  By selling higher Vol options and buying lower Vol options, when the skew reverts you benefit. 
• Second, trade management:  I took some early profits similar to the V trade.  (Click here) Note: the long calls I bought as cheap protection ended up worthless.  Had the underlying moved up a lot more they would have come into play, but the small rally didn’t affect them.  I lost a small amount on them.
• Third and final reason, time decay.  I almost always like to start with time decay working in my favor, negative gamma trading.

Just like the V trade, I had considered rolling my short Jul options to Aug but again there was no favorable roll and I would have locked in a small loss at best.  I decided to close the trade for a small loss on expiration day.  As most of you know, trading a liquid underlying’s options on expiration day it is difficult to get advantageous pricing as the market makers (and their computers) know you need to get out.  In ASML case, it’s not so liquid so that makes it virtually impossible to get out with good pricing on expiration day.  With that said, I’m currently long Sep puts naked as my short Jul I closed for $0.05 (Commission free to close short $0.05 options, thanks Tom at Thinkorswim) and I couldn’t sell my long Sep puts for a price I wanted. I now have upside risk.  I’ll close these remaining Sep puts at the open Monday unless ASML is going down, then I’ll monitor them and perhaps get lucky again. 

Note, these are not trade recommendations, click for legal disclaimer.

It’s rare that I am completely or mostly ‘out of the market’ but this is one of those times.  I tend to travel a lot in the summer and when the market cooperates I like to take profits and leave the city with small to no positions on to worry about.  On vacation I like to log on to Thinkorswim no more than once or twice a day.  With the recent downturn in the markets I have done very well and took off lots of profits…

However, going into the Independence day holiday vacation for a week, I can’t resist having some short delta trade on.  I really think we are going to give back a few more months of gains from the previous year long rally.  As my friends and readers know I never believed in the rally from March 2009. 

So, I want a low maintenance trade that I can look at once or twice a day on vacation that requires little to no work.   I would have liked it to be Theta positive but it starts off short Theta. 

Trade logic:

• I want to be short delta but have protection to the upside. 
• I want to be long Vega but not get hurt too badly if the market goes up and IV drops.
• I want to have a limited risk trade.

I like trading the OEX.  I get good fills, often better than theoretical prices.  It has good liquidity with 100’s to 1000’s of contracts of open interest.  It requires 1/10th as many contracts as SPY (hence 1/10th the commission, sorry Tom Sosnoff).

Here’s the trade:

First I put on an Aug / Sep $425 / $470 put diagonal.  (+10 Sep $470 puts / –10 Aug $425 puts).  This gets me long Vega and short Delta with a small positive Theta.  It has limited losses to the upside but is sensitive to a drop in IV.  It looks like this: (Click any picture to enlarge)

Next, I put on an Aug / Sep $475 / $480 ratio call reverse diagonal. (+10 Aug $475 calls / –5 Sep $480 calls).  This gets me long delta and long Vega and is short Theta.  Being long vega is a double edge sword here.  If the market moves in the desired direction, down, the long Vega will make this hedge lose less, but it also makes it a less hedge than it first appears.  However, it is very long delta so that lessens the long Vega losses on the upside.  On the downside it has limited losses and becomes more of a long vega play than long delta. This part of the trade looks like this:

The combined trade looks like this:

I like to use diagonal spreads more than calendars.  I often find that I’ll put on an OTM put calendar and I’m correct and the underlying moves down very quickly.  When a calendar moves too quickly you don’t make anywhere near maximum profit.  For a calendar to make (near) max profit the underlying needs to be at the short strike at expiration week, not right away.  With the diagonal spread there isn’t that change in delta after you cross past the short strike price. 

I also like the above ‘ratio call reverse diagonal’.  It’s positive delta outweighs the long vega on the way up and as time goes on, it becomes less long vega and if the underlying moves down the long vega offsets some of the short delta. 

Exit strategy: Obviously I would not hold this trade past the Aug expiration despite owning Sep options.  I’ll look to take profit or small losses if the underlying moves up quickly.  I’ll also take small losses if it stays in a tight range and suffer from the short theta.  If if moves down past $450, I’ll start taking off one or a few contracts at at time to lock in some profit but I will not be in a rush to do so b/c I’ll be long theta at that time and presumably benefitting from my long vega.

Have a nice Independence day, and hopefully enjoy your long holiday theta!

* Not a trade recommendation for education only. Legal Disclaimer, click here.

I am honored that Mark Sebastian at Option911 blog asked me to do a guest post again.

Please see his site for an article on using puts and put backspreads to protect a long stock portfolio. www.option911.com.

So, the power of IV is apparent in the trade from yesterday in MED

I’m currently above my profit target of $250, up $275 as of right now.  Just like I discussed, but even better:  The short Jun puts are up on a drop in IV even though the stock has basically stayed the same ($30.90 – $30.16).  The even better part is that the long Sep $30 puts have gained in price as the Sep IV has increased.

P&L is below: (click any picture to enlarge)

The Thinkorswim P&L graph is below.  Notice the live price is right where you want it at the short strike.  This trade has little risk now so I just sold half (5 contracts) at $2.98 to lock in $150 profit.  Since I have time on my side, I’ll hold this a little longer and see if I can take more advantage of my theta and vega position.

Below is the Live Vol Pro (www.livevol.com) chart of Jun (upper line) and Sep (lower line) IV.  Notice the Jun IV has dropped down and the Sep has angled slightly higher, consistent with our returns…

So, our tiny calendar has more than paid for the $100 / month Live Vol subscription fee… Not to sound too “salesy”, but Live Vol Pro is the best thing I’ve found to help find these trades.  I couldn’t imaging ‘trading vol’ without it anymore…

As usual, thanks for reading and I’d love some feedback, even just to say you’re here reading.  Comments in disagreement with anything I post are welcome and encouraged to start good discussion… Lawrence