Earnings Report: The Volatility Play (Short Straddle)

At the exchange we had to pick a stock and options strategy to go along with it. Here's the premise of the strategy I pitched and we went with to the group:
Wynn resorts and MGM had already came out with better than expected earnings. These companies' shares had risen dramatically the next day as a result of better than expected earnings. On July 26th, Las Vegas Sands earnings would be released. There is a historical correlation between the earnings of the three casino giants, so it seems plausible to the investing community that LVS will also beat expectations (however, yesterday Dell missed expectations, after its "peers," aka Apple beat expectations).

I believed that LVS, even if it beat expectations, would not see its stock price rise. The 26th is near the end of earnings season, and many companies had beaten expectations, if Sands DID NOT beat expectations, that would be a surprise. As such, I thought the stock would not move on the day of the 27th.

However, with an earnings report comes a great amount of uncertainty. The prices of options showed high levels of implied volatility. Stocks can move drastically after earnings, and as such options on LVS were very expensive.

Herein lies my strategy of a short straddle:
1) Sell an ATM ($46) Call for $2.43
2) Sell an ATM ($46) Put $2.01
Total credit: $4.44
If the stock goes up, I will lose on the call. If the stock goes down, I will lose on the put. But if the stock stays where it is, both options expire worthless, leaving me with the premium I collected for selling the options.

Notice how the maximum profit occurs if the stock does not move away from its current price of $46. 

On July 28th, earnings had beat expectations, risen in the aftermarket, and then moved to $45 (market was down, LVS actually did "less bad" than the rest of the market). When I sold the options, there were roughly 28 days till expiration. On July 28th, there were 25. However, to "buy back" the straddle (closing out my position), I would only have to pay $2.50 for the put, and $1.40 for the call: only costing me $3.90: A profit of $.54. This 54 cent drop in the cost of the option was not due to time decay (25 days instead of 28), but due to a drop in volatility. The market wanted to see how the earnings would play out: and the stock did exactly what I predicted - stay flat. The stock already had a better than expected earnings report calculated in the price.

The full strategy presentation can be found here: LVS Strategy Presentation. Start on slide 11.

The Week Ahead

Earnings come out this week - expect an interesting week!
http://www.cnbc.com/id/43769937

Who "Knifed" Apple? - Market Manipulation

I recently read an Article on CNN entitled "Who Knifed AAPL?" AAPL is currently trading at $353.
Below is the summary, with some more explanation behind it:

Sell some out of the money calls - say the July $360 calls for $2 each. This Friday is expiration Friday, meaning the option expires in 3 days.
Now, if AAPL goes up to $365, the calls are in the money, and the seller of the $360 will lose $3 ($5 in the money, $2 profit from sale).

To avoid this loss, the seller of the calls will try to lower the price of the stock to his own gain. He will sell stock to increase the supply of shares (simple supply and demand economics). This increase in supply will lower the price of the stock.
Here is the graph from last expiration Friday (which the article is based on).

Notice that volume increases very close to close. The article alleges this increase in volume is not legitimate trading, but traders looking to lower the price of the stock for their gain.
Then, on Monday, the traders would buy stock (if they sold short, or to re-establish a position).

Here is my parting shot: Apple's average volume is 14,828,000 shares. To increase the supply of shares drastically, you have to move a lot of shares -, at $330.
If someone really wanted to employ this strategy - they'd be doing it with a $5 stock with few shares. Exchanges have surveillance's in place, if traders were to attempt this strategy, a red flag would come up.

A Protective Collar

In my last post, I discussed a collar strategy. However, this strategy had the underlying assumption that the portfolio has no stock to begin with. The collar strategy was employed to limit risk and reward, given a certain set of speculations. Now, assume that an investor owns 100 shares of LVS (ended the day at $43.35). This investor wishes to keep holding onto LVS until September, but has a worry the company's stock may drop. The stock can not be below $39, when the investor plans to sell the shares (say, to pay for Fall Semester). A rise in the stock price will be welcomed, but not required.

The first option of the investor is to simply put a limit order, where the stock will automatically sell once LVS hits $39. However, if LVS hits $39 in July then rallies, the investor will have sold at the lowest point.

The second option is to buy a simple $39 put. This leaves all the upside, but this put costs $1.35. So, if the stock remains unmoved, the investor only nets $41.65 per share.

To off-set the cost of this 39put, sell an option for $1.35. This turns out to be the 48 call. This is a free collar, as the profit of selling the call pays for the cost of buying the put. If the stock goes up, then money will be made until the stock rises above the price of the sold call.

In summary:

1) Own 100 shares of stock.

2) Buy $39 put, for $1.35

3) Sell $48 call, for $1.35

Maximum risk: $43-$39 = $4 per share

Maximum reward: $48-$43 =$5 per share

Here is the P/L chart comparing the previous collar strategy (no stock) to one with stock. 

Remember an option only collar here involves

1) Sell the 39 put and

2) Buy the 48 put

 OR

1) Buy the 39 call

2) sell the 48 put

 Where the protective collar 

1) Own 100 shares

2) Buy the $39 put

3) Sell the 48call

Notice how the option only collar utilizes only puts or only calls where the protective uses both a put and a call.

"The Most Aggravating Trade Ever"

I saw a caller on CNBC ask about a similar strategy, so here it goes:

Let's say you decide that Las Vegas Sans (LVS) will rise to $47 by September. It is currently trading at $43. The caller asked "should I buy the $47 call?"
The answer is NO! The September 47 Call costs $1.6. So, if you are right, and the stock goes to $47, the stock is on the money, earning no profit. You will lose $1.6.  What is the most aggravating trade ever? Being right - and still losing money!

What about buying the September 43 Call for $3.3? To break even, the stock will have to rise to $46.3. If you are indeed right, and the stock rises to $47, you will only earn $.70. The maximum risk is $3.3.

Here is how you can use a bull collar spread to profit, while limiting downside risk:

1. Buy a $43 call. This will cost $3.3.
2. Sell a $47 call. This will earn you $1.6.

You will start to earn money,
The maximum profit is the difference between the two calls: $4, minus the net cost of the options bought:  $1.7. This will give you the maximum profit of $2.3, with a maximum risk of $1.7 (both options expire worthless).

Let's review our strategies assuming you are correct:

1. Buy a $47 Call. Risk: $1.6. Reward: $0.
2. Buy a $43 Call. Risk: $3.3. Reward: $.70
3. Buy a $43 Call, sell the $47. Risk: $1.7. Reward: $2.3.

Keep in mind that options are represent 100 shares of stock, so a risk of $3.3 is really $330 for buying one option.

Exercise by Exception Decision (EED)

EEDs – Exercise by Exception Decisions.
Let’s say a drug company’s stock is trading at $20/share. We will assume this for the entire blog post.

If you owned the “15 call,” then your call would automatically be exercised. The Options Clearing Corporation (OCC) automatically exercises “In the money” options. Who wouldn’t want to buy a stock for $15 – at the very least he or she can turn around and sell it for $5.

An option is a contract. It is a contract between the buyer and seller. For a “call,” the buyer has the right to buy stock for a certain price specified by the contract, and the seller must sell the stock to the buyer if the buyer wants to. The owner of the call may decide to take advantage of his option, even when it would not seem logical to: if the option is “out of the money”

You have a “25 call.” This means you have the “option” to buy the stock for $25. But you can buy it for $20 – so why would you ever buy it for $25? The “25 call” is “out of the money” it will “expire worthless,” as it should.

The stock market closes at 3:30CST. Let’s say at 4:00, the FDA approves the company’s drug for widespread use! You know this means that the stock will open at $30 on Monday – and shoot to $40 within the first hour.

Now, buying the stock for $25 seems like a good deal (you can’t buy it for the closing price of $20 because the stock market is closed). The stock you bought for $25 will shoot to $40, a $15 profit.

You want to take advantage (“exercise”) your option, and it will not be done automatically. Thus, you will submit an “Exercise by Exception Decision” (EED) to your firm. Your firm will thus exercise your position, leaving you with stock

DNED – Do Not Exercise Decision
Now, you own the “15 call,” then it would automatically be exercised, you don’t need to do anything. You will be buying the stock $15 when everyone else is buying it for $20.

This time, the FDA says “this drug kills people. No way are we putting this out. Go do a year of research.” This stock is about to shoot down! If you buy the stock using your option, you will lose money as the stock you bought for $15 shoots to $5 by Monday at lunch.

You will submit a Do Not Exercise Decision (DNED) to your firm. You will not want to exercise your “in the money” position, because you know that a buying stock for $15 is too high.

People need get their EEDs and DNEDs in by 4:30CST. After 4:30 CST it is against the rules to submit an EED. Our system spits out a handful of “late submission” warnings. I go through these and match up firm’s emails they sent us, to make sure they got the EED in on time (a 4:29 email won’t be processed on the floor till 4:31 for example).
If the FDA makes their announcement at 5:00CST, it’s too late. 4:30 is the cut off for an EED.

Buying a Put - Hedging vs. Speculating

The put is an powerful tool to the investor because it can be used as both a tool for the speculator and a long investor looking to hedge.

1) First, let's examine how a speculator can use a put:

Take Google, which recently had news that the government would look into its anti-trust behavior.  The stock is currently at $475 (rounded slightly). You believe that the price of Google (GOOG) will decline between now an August. One strategy is to short the stock; but that incurs the cost of borrowing the stock. In addition, potential margin calls and unlimited go along with shorting equity.
Herein come options:

Say you believe the stock will fall to $450. The $475 (The At The Money) put option is currently trading for $20.50.  If you are indeed correct, then you will make $4.50 per stock ($450) total. The break-even point of a speculation put for this option is the strike ($475) minus the cost ($20.50):
475-20.50=$454.50.
If the stock drops below $454.50, then money will be made. If the stock is indeed $450 in August, you will buy the stock at cost ($450) then exercise your put. This put gives you the right to sell the stock you bought at $475, a $25 per share gross profit. Subtract the $20.50 you paid for the shares, and you have a $4.50/share profit.

If you are wrong, and the stock shoots to $550, you can only lose the $20.50/share ($2,050) you bought the option for.
Shorting equity would equate to $75/share ($7,500). A "stop order" can be placed if the stock raises (say, above $500). This will limit the loss from being wrong. However, if the stock rises above $500 before dropping to $450, a short position would lose money, where the put would profit.

2) Let's now assume you own Google. You are long Google, believe in the company, but are worried about the downside of this potential lawsuit. In that case, you can buy a put to protect your investment. You can hedge your position as follows:

Let us say that you buy a $475 (the current stock price) put. If the stock goes up to $550, you make money (profit $75/share), as you own the stock, but the put expires worthless. You lose $20.50/share on the put, for a net profit of $49.50/share.

Now: Assume the stock goes to $450. You can use your put to sell the stock at $475, curbing the potential loss from the stock's drop. Instead of losing $25/share, you only lose $20.50/share.

Here are the three strategies compared side by side. Notice that a hedge put makes money by the stock increasing in value, where a speculating put earns money by a drop in the price. The traditional long will out perform the hedge put, but has a larger downside risk.