Around 2 PM is a good time to look for pins in the above stocks, though AAPL and MA move around a lot.

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.

Buy Straddles

The first idea is to buy an at the money straddle. RIMM closed today at 49.09, so we should look at the 50 straddle. The call sells for $3.30 and the put for $4.35. That means we would have to pay $7.65 for the straddle and the stock would have to go to 57.65 or drop to 52.35 for us to break even. That is a tall order. (By the way, RIMM is trading at 58 right now in after market trading.)

Why are the options so expensive? It is because the implied volatility is so high leading up to the earnings announcement. The uncertainty in what the earnings will be pumps up the implied volatility. The market remembers that Research in Motion makes large moves on earnings announcements and the options prices reflect that. The April 50 call has an implied volatility of 89% and the April 50 put has an implied volatility of 92%.

Sell Straddles

So maybe it is better to sell straddles and profit from the collapse in implied volatility. If we sold the straddle we would get $4.25 for the 50 put and $3.25 for the 50 call. We would earn $7.50 in premium so our breakeven points would be 57.50 and 42.50. As mentioned above, RIMM is trading at 58 after the market close, so that position would be a loser.

What we want to do is to profit from the coming collapse of implied volatility but not suffer if the stock moves too much. How can we accomplish that? If we sell the April options and buy May or June options we might be able to accomplish both goals. The May 50 puts have an implied volatility of 74% and the June puts have an implied volatility of 72%. This is near the top of its usual range. The bottom of the range is 50%. So we would expect the April volatility to drop to 70% or so and the May or June volatility to stay around 70%. It is possible that the May and June options implied volatility will drop to 60% and the April options will also.

Double Calendar Spread

So I sold the 35 April put and the 55 April call last week and bought the June 35 put and June 55 call in a spread. The way I thought of it was that the wider combination gave the stock room to roam, the near option volatility would collapse and the later month options would protect against large moves.

Let’s see how it plays out tomorrow.

I looked for some more earnings announcements to trade yesterday.  Here are the results for three of them.   The thinking is that there is likely to be many surprises in earnings announcements these days since earnings are very volatile.

Southwestern Energy

Southwestern Energy drills for gas throughout the South.  It announced earnings after the close yesterday.  It looked like there was no surprise.  The aftermarket trading was mostly unchanged.  This is what happened to the options.

date  2/26/2009          2/27/2009

SWN         27.70                    28.00

30 call     1.2                           1.1

25 put      1.0                          0.65

Total        2.2                          1.75

So the call was within ten percent but the put lost 35% of its premium.

Autodesk

Autodesk makes 3D design software for architects and chip designers and also 3D manufacturing software, known as computer aided design and computer aided manufacture.

date  2/26/2009          2/27/2009

ADSK      14                                13

15 call     0.65                           0.1

15 put      1.45                          2.2

Total        2.1                            2.3

ADSK had dropped 7% by the time I closed out the trade this morning,  and the options gained 10%.   The calls really collapsed in value.  While the puts had a delta of 75%.  They moved 75% as far as the stock.

Deckers

Deckers is a shoe manufacturer.  Their most popular product is those ugly UGG boots.  Ugly, but very popular.

date  2/26/2009          2/27/2009

DECK         53                             42

55 call     4.26                           0.25

50 put     3.17                           8.3

Total        7.43                            8.55

Deckers dropped 20%, a very large move.   Here we see that we couldn’t take full advantage of that move because the call had dropped so much.  Our return is only 15% not counting commisssions.

Research Questions

One thing to look into is how much does the initial move continue into the trading day.  What I mean is, maybe it was a mistake to close out the trades in the morning.  Perhaps it is better to let the trades that have big moves keep going through the day and close out later.

Another issue is, does the options open interest and implied volatility on the  day that the trade is placed tell us anything about the direction of surprise?

Things to think about.

Here is the chart that shows the result:

Date          2/25/2009        2/26/2009
Stock   FLS     46                          54
45 call             4.1                           8.3
45 put             3.8                           1.2

Total               7.9                           9.5

Return 1.6 / 7.9 = 20%

Yesterday, I bought the 45 straddle, that is, calls and puts both with a strike of 45 which was close to where the stock, Flowserve, was trading. It cost me 7.9 for each straddle. They announced good earnings last night so the stock opened much higher. Around 10 AM I sold the straddles for $9.50 each and made 20%.

Really, you only need to hold the position overnight. The risk is that the volatility goes out of the options and they collapse in price. But right now earnings are very volatile and there are a lot of surprises. So it seems to me that this is a fairly safe trade.

More to come tomorrow. I will try a few more of these trades overnight tonight.

Predict Price Direction

If you predict price direction then that tells you what options to buy or sell depending on your risk profile. For example, if you think that the Dow is going to drop some more you could:

• sell DIA short or
• sell a call and buy a put which is a synthetic short stock position.
• Or you could buy 10 at the money puts and sell some in the puts to pay for them.
• you could sell calls.

Options are so flexible that you can express any opinion with any degree of risk that you want to take. The way to decide, I think, is to look at the payoff graphs and see what the losses are like if you are wrong.

Predict Volatility Direction

He talks about traders who are tired of trying to predict price direction, so they trade volatility trying to take price direction out of the mix. If you think that volatility will collapse, say after an earnings announcement, then you can sell a combination around the current stock price. I did this yesterday by selling the First Solar (FSLR) March 155 call and the March 115 put. They announce earnings after the close today. I also sold the Flowserve (FLS) March 55 call and March 40 put. They announce earnings tomorrow.

So these are short term delta neutral trades, if the price doesn’t move too much.

I will give the post mortem on them in a few days.

You can take this further, try to increase the range over which the price doesn’t move by constructing a gamma neutral and delta neutral trade Gamma is the rate of change of delta with a small price change of the underlying.. That gives you more time to wait for the volatility to change in the direction that you are betting. If you are looking for volatility to drop, you sell an April combination symmetric around the price of the stock and buy March options at the wings. Done in the right proportions, this will be both delta neutral and gamma neutral. The months have to be different for the trade to work.

All the possibilities makes my head swim,.