Volatility Trading Digest: Straddles & Trend Changes
Straddles
The table in this posting summarizes potential straddles going into their respective earnings date. The idea is to establish the position before the implied volatility starts to increase in anticipation of the report. Implied volatility reflects uncertainty or the width of the possible stock price distribution. While these companies have experienced increasing implied volatility when they previously reported, the level of uncertainty for the current report may not be comparable. Indeed some companies are on the list one quarter and not the next while others remain quarter after quarter. Further, since the implied volatility of the market as measured by our IVXM as well as VIX shown above is now at the lower end of its range the implied volatilities of the individual stocks are also lower. If the market implied volatility as measured by the S&P 500 Index starts to rise, our straddles will benefit since the positions are long volatility or vega and are indifferent to small price changes.
The difference between the current implied volatility and the estimate is more important than the highest estimated value as it measures the potential increase. For Example AMZN in column 6, IV Est/IV, at 2.08 has greater potential to increase than CMG at .97 presuming all other variables remain constant.
We want to use straddles that expire well beyond the earnings report date. Since the position is long two options time decay is the primary concern. However, by using longer dated options we minimize the time decay while increasing the sensitivity to increases in implied volatility or vega. For example, using a January straddle for AVP will have less time decay loss than a November straddle for FB and will have a higher total vega.
Our display space is limited so we are unable to show the next three columns. By dividing the straddle cost by the stock price, we determine the straddle cost percentage. Then we divide by the number of days to expiration to determine the daily percent cost. Then the final step is to divide the daily percent cost by the IV Est/IV ratio in column 6 to determine which have the best daily percent cost relative to their potential increase in implied volatility.
When we select the ones with straddle costs of less than $10, since the total cost is also important consideration, we reduce them to eleven alternatives. Then ranking the best three from the lowest cost relative to the potential gain, we have these candidates:
UA,WFM,AVP
Since the position will be long time value, check the implied volatility frequently, at least weekly. If it does not begin to increase as expected close it.
Straddles are delta neutral positions so large stock price changes will alter all of the option Greeks requiring adjustment back to delta neutral going into the earnings report date for the best results.
Further, since the plan is to close the position on the last trading day before the report, it is necessary to check for any changes in the reporting date.
Finally, this is a work in progress so if anybody has suggestions for additions to the list please let us know.
Trend Change
United States Oil (USO)
We have been expecting the seasonal decline in crude oil for last two or three weeks and now on the decline last Tuesday when it closed at 35.57 below our upward sloping trendline from the June 28 low at 29.02 and then gapped lower the next day, it looks like the seasonal decline has begun. In an environment of slowing global economic growth, it seems likely to return to the 30 level in the absence of the often-cited Middle East risk premium.
Here is the options data.
The current Historical Volatility is 20.29 and 18.12 using the Parkinson’s range method, with an Implied Volatility Index Mean of 30.24, up from 30.23 last week. The IV/HV ratio is 1.49 and 1.67 using the range method to calculate the HV. Friday’s put-call ratio at 1.05 was bearish while the volume was 103,536 contracts traded compared to the 5-day average volume of 142,520. Consider this put spread idea.
USO-put spread idea
At 27% of the distance between the strike prices, it has a good risk to reward ratio and volatility edge. Use a close back above the upward sloping trendline at 36 as the SU (stop/unwind).
Earnings Report & Trend Continuation
For a trend continuation idea, here is one in the homebuilding sector reporting Tuesday that we previously suggested in Digest Issue 34.
PulteGroup, Inc. (PHM)
Their homebuilding business includes the acquisition and development of land primarily for residential purposes offering various home designs, including single-family detached, townhouses, condominiums, and duplexes under the Pulte Homes, Del Webb, and Centex brand names. Scheduled to report 3Q earnings Tuesday before the opening, the consensus estimate is .20 per share.
The current Historical Volatility is 38.41 and 39.88 using the Parkinson’s range method, with an Implied Volatility Index Mean of 45.94 up from 43.31 last week. The IV/HV ratio is 1.20 and 1.15 using the range method to calculate the HV. Friday’s put-call ratio was bullish at .30, while the volume was 17,719 contracts traded compared to the 5-day average volume of 18,530.
Here is a put sale for the earnings report to supplement the position from last month presuming it declines somewhat on Monday as is typical.
put sale
Use a close back below the upward sloping trendline at 12.50 as the SU (stop/unwind).
The suggestions above use the closing middle price between the Friday bid and ask. Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.
Summary
After September options and futures expiration last week that probably supported prices and since there is no near term overhead resistance, we expect the S&P 500 Index to continue higher after a brief correction or pause to resolve the current overbought condition.