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.

My LinkedIn Strategies, cont. (Strangles and Butterflies)

In my post last week, I discussed two straddles of LinkedIn. Today, I'm adding two strategies traders who expect the price to move in either direction can employ.
Note: the price of LNKD has moved since my first post - so some numbers have been updated for this part.

1) A strangle:
A strangle is a form of a straddle, but unlike a straddle, the strikes of the calls and puts are different. For this example, I will buy a $60 put and a $90 call.

Because the strikes are away from the money, they are cheaper in time value premium. Thus, buying the combination will cost less than buying two ATM positions (the $75). Thus, the maximum loss is the cost of the call and put: $6+$17 = $23. However, to beat the spread and cash in, the options need to move
A) $23 higher than the $90 call, or
B) $23 lower than the $60 put.

This spread is harder to cover than a traditional straddle, and provides less reward. The blue line (Strategy #2) is a traditional straddle.

2) A Butterfly

A butterfly is the least risk strategy of the three for betting a move in the stock price, but offers the least upside. For a long butterfly, do the following:

1) Buy two ATM calls

2) Buy an ITM call

3) Sell an OTM call.

In this example, the net premium is the profit of the OTM ($60) and ITM ($90) calls minus the cost of buying the two ATM ($75) calls. $6+$17-2*$9=$5 net profit. 

However, if the stock price does not move, the $75 calls you bought will expire worthless, as is the call you sold at $90. The $60 call you sold is $15 in the money, so the buyer will exercise the call. Thus, your net profit of $5-$15 = -$10. A loss of $10 per share is the worse case for a butterfly.  The green line seen below is a butterfly.

• As the stock approaches $60, the $60 call will be less In the Money, which makes your profit rise (as you have less of a spread to cover)
• Once the stock moves below $60, all the calls will expire worthless, and you will profit the net $5 from the sale and buys of your calls.
• As the stock approaches $90, one of your $75 calls offsets the short $60 position, and the other $75 call will profit.
• If the stock moves above $90 - you can not profit even if the stock goes higher in value. Your short and long positions are canceled out, and the only profit is the net premium from selling the calls.

A question that arises with strangles: do I buy two OTM positions, ITM, or ATM? The answer: it doesn't matter (yes, I rounded).

The final warning: If volatility goes down, then both the calls and puts will lose money - even if the stock moves! These positions seem simple, but it is simple to see long positions expire worthless and the loss associated with the premiums.

What strike to buy?

I just talked to a British trader about Sirius radio. We discussed what option strategy to pursue if he believes the stock price will rise. Unfortunately, Sirius provided problems as an example because the strike prices were too close together and too small to truly show on my graph (premiums of a penny). So, I have picked Home Depot (HD) with the following information:


We believe the price will rise to $50 (so this is a Bullish spread). The question is: which option to buy?

As the strike price increases, the probability of the stock price reaching that price goes down. As such, we see the "time value" of the following options as the following:
 (there is rounding, which is why these numbers differ slightly)
Note there is no intrinsic value because these are out of the money calls.

The green line (strategy #1) is the $35 call, the blue line (strategy #2) is the $40 call and the $45 call is the red line (strategy $3)

Note that as each strategy becomes less risky, its upside reward lessens. Buying the $45 call is cheaper than buying the $35 call, but only earns $5 if the stock goes to $50. On the contrary, if you are wrong and the stock does not move, the $45 call has a max risk of $.05, where the $35 call risks $2.25
The $50 call is On the Money, so buying a $50 call would mean you would lose your $.03 ($3 total).

Well, what about buying an In the Money Call?

Here, we see an In the Money, At the Money, and Out of the Money compared: (notice that strategy #1 - the green line, is now an ITM call)

The ITM call has the best reward payoff, but the most downside risk. If you are wrong, and the option price falls to $25, the entire $10.5 you paid will now be lost. 

There are two more strategies that can not be over looked: a long position and selling a put.

Here is the following information for an At the Money Call and Put:

Selling a put allows you to gain if the stock moves, but you will lose the most from a drop in the price. The red line represents a traditional long strategy. The green line is our ATM call, though this could be exchanged with an OTM or ITM call depending on an investor's goals (as we discussed above)

Practice Trading Options

This is the site I use when I'm practicing trading. It's easy to use and doesn't require a fee:
http://www.cboe.com/tradtool/virtualtrade.aspx

Microsoft Excel Profit/Loss Diagram Uploaded!

I have uploaded the Microsoft Excel worksheet I used to learn option strategies.
I consider diagramming profit and loss a solid way to see different strategies. I have tried to create the simplest and most informative interface on the web.
Click the link on the left hand side of the screen. Please give me any feedback you have on it. 

A Basic Straddle

If you have a stock that you know is going to move, but unsure of the direction, options allow you the opportunity to profit with this mindset. I’ve been perplexed with LinkedIn (NYSE: LNKD) since its IPO. The fundamental question is: Is it the next Google ($500/share) and Apple ($320/share) or the next Yahoo ($14/share)? LinkedIn is currently trading at $75 per share. I believe it could either go down to $20, or all the way up to $120.

The simple answer using options is to peruse what is called a straddle. I will be using the FEB12 LNKD series.

The first, and most basic strategy is a straddle:

1)      Buy an ATM Put

2)      Buy an ATM Call

Reward: Unlimited on the upside, limited but substantial on the lower side. If the stock price goes up to $120, the put will expire worthless, and the call will be in ITM and exercised for a profit totaling $1100. If the stock goes to $20, the call will expire worthless and profit will be made on the put, earning a net $2100.

Risk: Limited. While this seems like a fool proof strategy (profit in an up or down market), the move that the market must make in order to profit is quite large. LNKD must move from $75 to either below $41 or above $109 to profit. If the bet is wrong, the potential profit loss is the cost of both options the 75C@15 and the 75P@19, or $3400 total.

Time erosion: Hurts position.

Increase in volatility: Helps position.

Another strategy will use equity in addition to options. By “marrying” stocks together with options, here is an example of strategy #2.

1)      Buy 50 shares of LKND

2)      Buy an ATM Put

Here we see one of the most fundamental rules of trading: less risk, less reward. The marrying strategy allows for less risk than a normal straddle. If the stock price remains unchained, the put will expire worthless, but I will still have my underlying stock. A traditional straddle, both the call and the put would expire worthless. However, any loss of value of the stock will increase the value of the put, but lower the value of the shares in your portfolio.

Neither strategy is “better” in an absolute sense. Both have the same risk/reward scenario, but in different ratios. Finally, many brokerage firms will allow you to buy a straddle as one item, paying commission only once. The marrying strategy is two separate trades, and commission will be taken as such.

In my next post, I’ll examine two more strategies that could be used given my beliefs about LinkedIn: a strangle and a butterfly.

Welcome!

After learning the basics of the options market, I was eager to use my newfound knowledge of options to create the various strategies I learned in my classes and the internet. However, I was very unimpressed with the current tools on the Internet. I felt there had to be an easier way to graphically depict potential profits and losses associated with options. So, I created my own. Using this tool created in Micrsoft Excel, I can easily plot various option strategies.

On this blog, I will explain some simple to intermediate level options strategies, using my program to graph strategies. I will not go very detailed into the delta, gama, vega, or rho’s of options, but stay more with the goals and risks of each strategy.