Skew trade in APC

Today I was scanning for  “exploding IV30’s’” in LiveVol Pro and came across APC, Anadarko Petroleum.  Headlines said that they were being investigated in their involvement in the BP oil spill causing IV to increase.  You can see the Skew chart below showing the Jun options inflated over the back months and a pretty steep horizontal skew as well. (Click any picture to enlarge).

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You can see in the below chart of front and back month IV that the IV spiked and is now trending down for both front and back months.

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With the underlying trading at $45.44 I bought a diagonal spread: +20 Jul $45 puts (65% IV) / –20 Jun $42.50 puts (79% IV).

Trade Logic: I’m taking advantage of both horizontal and vertical skew by buying back month lower IV and  selling front month higher IV, and also selling lower strike puts with higher IV.

The Thinkorswim Analyze tab looks like this:

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After my entry APC closed down a little today to give a small profit in the trade.  Interestingly, you can see in the above picture that had the underlying not moved all from my entry at $45.44, the white line is above the breakeven line indicating that the volatility differential has closed a bit between back and front months allowing some profit (helped by just a tiny bit of theta).

Exit strategy: I’ll stop out on the upside if APC goes above $47ish.  I’ll take small profits one spread at a time as either the underlying goes down or Theta / Vega work in my favor.  Stay tuned

*note: No posts are trade recommendation and merely for education and entertainment.

2 Responses to Skew trade in APC

  1. Hi,

    Thanks for a great post. I was wondering how do you decide on the strikes to buy/sell. In the APC trade your strikes for the diagonal were pretty close whereas for the Visa trade you had put on wider strikes.

    Thanks,

    • Hi Sandeep, thanks for the comment.

      With risk of sounding ‘imprecise’, I don’t have a set criteria when I do these, and all, trades. I start by looking at the skew charts to see what vol I want to sell and buy. Then I model the trades in thinkorswim and see what provabilities of success I have. I’m very visual in my trading and have developed a feel for the P&L charts. I also try to model possible outcomes. To do this, I look at the option chains and try to predict where IV will go based on the IV of higher and lower strikes of the same month. For example, if APC Jun $35 put is trading with IV of 107% and is 5 points out of the money and the $40 strike put is 90.5% IV, I assume that the if the underlying drops $5, the $40 strike IV will increase by 16.5% in my models. Hope this helps.

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