Here Goldman Sachs settled down around 11 AM. Then between 2 and 3 PM it wandered off plummeting to the strike at the close.

BIDU just took off, but we didn’t think it would pin, did we?

Google is often a good pin candidate. Look at what it did today:

Apple likes to wander, but look how well behaved it was after 1 PM.

CME was quiet but not pinned. Look at the chart.

RIMM and CME are far enough away from their strikes that the intrinsic value in the options make their probability low.  Have to look tomorrow where the straddle is if they get near the strike.  The BIDU and MA straddles look under priced.

This is what I’m looking at for tomorrow.

Pinning Candidates

It looks like the top two, Goldman Sachs and Apple, are prime candidates to be pinned at 120 tomorrow. Goldman announced earnings early this week, so there shouldn’t be a lot of news out tomorrow to move the stock. That is, unless Citibank’s earnings announcement tomoorw morning shakes up all the financial stocks.

Google

Google is all over the place in after hours trading after its earnings announcement.  Who knows if it will stabilize tomorrow morning near a strike.  The open interest is wide and deep for Google options.  So we will have to see at 10AM.  It might happen that Google will have momentum tomorrow so that a more directional bet would make sense.  If it is moving up, then one could buy a call just above where it opens and sell two or three calls at the next higher strike to pay for it and make the trade close to delta neutral.

Rest of the List 

Research in Motion (RIMM), First Solar (FSLR), and Mastercard (MA) are good candidates too.  The others on the list, Autozone (AZO), Baidu (BIDU), and Chicago Mercantile Exchange (CME) don’t have very many puts. So they aren’t very good candidates for pinning.

Monte Carlo Results

What is the probability of a successful trade? Which trade is the most likely to succeed? To answer these questions, I ran the Monte Carlo simulation for each straddle. The inputs are the stock price, the straddle price, the number of trading days left, the interest rate, and the historical volatility of the stock. The output is the probability that the stock wanders past the break even point on either side.

Some of these look better than others.   The best one is Google, only a one percent chance that it will wander outside the break even points.  Of course, this isn’t correct.  The volatility of the straddle will collapse tomorrow morning making the break even points closer together.  We will have to recalculate that one in the morning.

Notice how different GS and AAPL are.  Though they are at the same stock price as can be seen in the top table, and the at the money straddles are the same value, the trades are very different.  It is because Goldman Sachs has a much higher historical volatility.   

I believe that the probabilities are upper bounds, because of the extra pinning effect of the options on either sides of the strikes.  Still, I would sell more straddles of the stock that had the lower probability.

This is the “picking up quarters in front of a bulldozer” trade.

Usually, what they are touting is selling far out of the money options. You will be paid a quarter in premium and 95% of the time the stock you are selling the option against does not reach your strike. But 5% of the time it does and all the profits from the 19 successful trades is wiped out by that one bad trade.

Let’s look at an example. We’ll take Baidu, since there is a chance to make more than the transaction cost in that stock.

Baidu

Today is Tuesday, so there are three days to Friday’s close if we put the trade on near today’s close.

The one day one standard deviation move averaged over the last twenty trading days in BIDU is $7.24. To look at the three day one standard deviation price move we multiply this by the square root of three, since price is a random walk. That gives us $12.54 as our one standard deviation move over the next three days. This means that we expect BIDU to end up within $12.54 of its current price 68% of the time after three days. Since it is trading at $173 that means at Friday’s close, we expect BIDU to be between $160.46 and $185.54

If we want a bigger margin of safety, we can go out two standard deviations to plus or minus $25.08. That is, 95% of the time, after three days of trading, a stock with a normal distribution will be within two standard deviations. That gives us a range of $147.92 and $198.08.

Let’s see what we can earn in premium two standard deviations out. The $200 call is selling for $0.05 and the $145 put is selling for $0.25. So if we sold the pair we would be credited with $0.30.

We can do a different analysis and look at the actual tradinig of BIDU, and that way not make any assumptions about its distribution. If we do that, we find that from 31 July 2007 to yesterday, 16th March 2009 there were 410 trading days and 409 price changees.

Looking at those price changes, there were 18 that were bigger than two daily standard deviations and 14 that were smaller than -2 standard deviations (that is, big moves downward). That gives us a probability of 32 / 409 = 7.8% to have a bigger than two standard deviation move in one day. If BIDU’s price changes were normally distributed, that should be 5% so it looks like BIDU has more large moves than the normal distribution and we are closer to 92% safe in this trade than 95% safe.

To give you a fuller picture, of the 18 one day moves that were bigger than two standard deviations, one was a five standard deviation move, two were four standard deviation moves, five were three standard deviation moves, and ten were between two and three standard deviation moves. The downside is safer. Of the 14 big moves there, two were between three and four standard deviations and 12 were between two and three.

So it looks like it is safer to sell the puts. You also make more premium.