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

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!

Earnings trade management post earnings, an update on OTEX

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

So, last I reported OTEX was up in the PM after reporting good earnings.  As I predicted my short SEP calls lost their extrinsic value but unfortunately gained lots of intrinsic value as the underlying moved up. 

My plan was take a loss if OTEX moved above it’s opening high at 9:35am.  Well, not all things go as planned.  I was busy with my regular job seeing patients and by the time I checked the price near the close OTEX had made new highs and was heading down into the close.  I held…

The next day, Friday I was in surgery at the open.  After my surgery I check the price and figured I’d hold and see if OTEX would go down to fill the gap.  I was in surgery all day and when I checked at the end of the day, the gap was not filled and OTEX was pretty much even all day.

Today, Monday, I decided to use my upper end of the opening gap on earnings as my stop out.  OTEX was flat all day and I’m still holding waiting for either a stop above the earnings gap, $43.14 or a move down to take some profits.  At this point there’s little theta effect so holding isn’t terrible.  I’m very long Vega so a move down will benefit me more than the current P&L chart below shows.  (click any picture to enlarge)

I’ll keep you posted on this trade.  As you probably can tell from reading my previous posts, I’m always more comfortable in the current market being bearish.  I am still (still still still – it seems) bearish on this economy.  If this trade were positive delta I would have taken it off already.

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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

UPDATE OTEX trade management after earnings release

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

If you have not already, please read my guest post at Option Pit (Click here) prior to reading this post.

So, OTEX reported, “profit up on higher revenue and cost cuts”.  Premarket the shares are up from their close of $37.25 to $41.  See chart below: (click any picture to enlarge)

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At $41 our trade is suffering the max loss I predicted yesterday to the upside as of this writing premarket.  (See P&L plot below) When the market opens I’ll look to close my short puts first and then see if there’s any decrease in underlying price as I think today should be a down day with the terrible jobs numbers…

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UPDATE: 09:31  Ok, so the market now is open and OTEX is up around $43.80.  I bought back my short $35 Sep puts for $0.10 for a nice profit.  Now I will watch to see the price action of OTEX.  I predict it will hit it’s highs at the open and spend the rest of the day retracing it’s gains. 

UPDATE: 09:51  As predicted OTEX hit it’s high If it makes a new high on the opening 5 minute bar and has come down some.  I’ll continue to monitor now.  The 5 minute chart and current P&L plot after the short put was closed are below.

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I will continue this post later today, stay tuned.