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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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.

MCK – out of the rest – an earnings trade gone well

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

Click here to see my MCK earnings trade setup and trade management.

This morning at the open I closed the remaining spreads for a debit of $0.14 for each 3:2 spread.  On 7/29/10 I entered this trade for a credit of $2.70. 

This trade went exactly as planned.  My prediction were spot on for IV and direction.  (click picture to enlarge)

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DIS – Managing this earnings trade that has become short Theta

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

So, yesterday I didn’t get to exit my DIS trade like I had hoped to.  My regular readers know that when a trade moves in the desired direction I often take my time to get out in small increments, however, with this trade I’m anxious to get out.  Most of my trades are theta positive and with time working on my side I don’t rush to exit.  This trade is theta negative and time is working against me.   I am long back month options and short front month options but still theta negative.  This is because there’s so little extrinsic value left in my short Aug options due to OPX being only 8 days away and because of the Vol Crush that occurred after earnings.

This trade is very short delta and the futures are showing some weakness pre-market and so is DIS (on very light volume).  I’ll monitor and start exiting today. (click picture to enlarge)

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