Skip strike unbalanced butterfly spread in EXC

Posted by: Admin: "The Vol_Trader"  //  Category: Volatility Trades

Sorry for my absence lately.  I’ve been consumed with starting two new small businesses.(Not trading related.)

Today, I’m back with an interesting trade I will call an ‘unbalanced or ratio skip strike butterfly spread’.

The trade is in EXC. My trade logic is:

EXC announced earnings that disappointed.  The stock went down and has continued it’s downward move for the subsequent two sessions. (Trade was placed yesterday 10/26/2010 and it’s down again today as of this writing).  The daily chart is below: (click any picture to enlarge)

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You can see a clearly bearish trend over the past year.  The recent down move has broken down below support since mid Sep. 

Interestingly, IV did not move up with this large point decline.  The below six month chart of 30 and 90 day volatility (source: Live Vol Pro) shows that IV only moved up slightly into earnings and was (and still is) well below the historic implied volatility for the past six months.

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Below you can see the recent large move down without a corresponding pop in 30 and 90 day implied volatility.

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With all of this info I’m predicting a further move to the downside in EXC and an increase in implied volatility over the next 90 days.

The trade: +10 Jan $47.50 puts / –30 Jan $44 puts / +40 Jan $39 puts

The profit and loss chart look like this (Source Think or Swim):

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EXC is currently trading at $40.60 as of this writing.  At expiration this trade is profitable above $41.86 and below $36.15. 

Below you can see the chart of vega vs. underlying price.  The trade is very long vega at the money and down to $36ish.  It is short vega above $44.

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As I always say, I’m entering trades like this to take advantage of the implied volatility in addition to picking direction.  If the underlying moves up and I was wrong I will become long theta and can wait for decay to work in my favor or get out with a small loss.

If the underlying moves down quickly I’ll profit from my short delta (direction) and from my long vega as implied volatility increases.  This is the result I’m looking for.

My risk in this trade is a slow move to the downside with decreasing implied volatility.  My risk is defined to a maximum at $39 at expiration.  Luckily, markets tend to move down quickly and up slowly. 

Exit plan:  I’m hoping to get a quick downside move prior to expiration and take profits.  An explosive move to the downside would work very well.  If I am given a profit I will sell off a few contracts at a time taking profits.  If the underlying moves up I will likely take a small loss to a small profit depending on what volatility does.  Since it is already low on the charts the volatility may not drop much and I’ll have a small profit.

Thanks for reading. Please send comments.  I have some comments from my last post that I’ll address in the next few days.  Again, sorry for my absence…. – Lawrence

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