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)

image

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

image

image

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

image

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.

image

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:

image

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:

image

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

A long Vega trade in OEX

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

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)

image

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:

image

The combined trade looks like this:

image

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.