Chipotle Mexican Grill

First, let’s look at past earnings announcements and the close to open change in price.

It’s trading at 90 and the 90 August straddle goes for $10. So we could try a calendar at 80 and 100.  (Click on the charts to enlarge).

If after earnings tonight, the volatility of the August options collapses to the September values the return graph for tomorrow is the colored curve. It is positive from 80 to 108. (Click on the charts to enlarge).

Return After Volatility Collapse

Intuitive Surgical

Here is a table of the last few returns from the close just before earnings to the open right after earnings are releases.

The ISRG straddle is selling for $22.50 or 13.3% the average move on earnings is 0.32%, but the average absolute move is 8.82%. So 13.3% is still high. They are expecting a large move. Let’s see what the dual calendar spread would do if we center it around 145 and 190. (Click on the charts to enlarge).

If the volatility collapses, we have:

but basically, just look for generally uptrending names, and then short some puts into mini dips

My guess is that the mini dip where he sold some puts was at the point marked 1. My guess is that he sold 105 puts. Just to keep the trades concrete, say he started out short 10 July 105 puts. I don’t know and he won’t say.

The “T” on the chart labels the day that ICE fell through the 105 strike like a hot knife through butter. AW was in trouble.

So I ended up covering by turning the put short into a butterfly, going long the 100 strike. That was the mediocre.

Long twice as many 100 puts as he was short 105 sounds good to me. Of course, if this is a butterfly, then he was also short, maybe, the 95 puts. So now our hypothesis is that his position is:

-10 105 P,
+20 100 P and
-10 95 P

And he has turned his profit distribution from this:

To this:

Look at the purple line, since that is where the position is when it is put on. He is working his way to breakeven if ICE keeps falling, but no better than break even. Hence “mediocre”.

Stock kept going lower, so then had my one good idea. Just converted it to long downside gamma by shorting more 105 puts so that I was now short the 105-100 put spread 1:1, and then bought an equal number of 95 puts and a little stock.

So the hypothetical position now looks like:

-20 105 P
+20 100 P
+20 95 P

The position gets to break even at 86. Which is where it closed Friday.

That part worked out well yesterday as the stock imploded. The only thing holding me back was….well, me. I got short and shorter thru 95 and was patient all the way until….the 91’s. Which sounded great at the time, not knowing it would go to the 84’s. By which time I bought more stock and kept the long gamma game going by purchasing some July 85 puts.

Roll it all up and a lot of trouble to pretty much break even, although even sounds good compared to the initial ugliness of my put short. I’m now just long some gamma. For the moment, will probably sell some “wings” (OTM puts and calls) and call it a day.

A good recovery.

OK, I’m pretty sure I heard CNBC Chief Apple Stenographer Jim Goldman this morning mixing in talk of Steve Jobs New Liver and the recent volatility in AAPL shares.

Um, no.

The graph here shows 10 day realized volatility in AAPL over the past 52 weeks. If by “volatile” he meant “52 week lows” then he spoke correctly.

Basically this pattern in AAPL exists all over the street, which is part of why options in general are not a great buy right now. This despite the fact that options are as cheap as they’ve been since last September. AAPL July options carry a 37-38 volatility or so, which sounds very reasonable compared to prices any time over the last 9 month’s, but in fact you would need stock volatiltiy to double from recent levels to have them pan out. It could happen of course as stocks do suddenly catch fire (see POT from last week). Just keep in mind that if you see an uptick in stock volatility, it’s already priced into the options.

Options order flow has the most value when it goes against the grain of the stock. Like this one.

Houston-based oil driller Smith International (SII) is down $1.29 to $25.22, as a pullback in crude oil weighs on the drillers Monday. Crude was recently down $2.42 to $67.13 a barrel. However, while SII shares are falling, sentiment seems bullish. July 30 calls are the most actives, with 3,250 traded and 80 percent of today’s volume hitting ask-side. Another 1,290 July 37.5 calls traded, with 70 percent traded ask-side. While today’s volume doesn’t yet exceed open interest, ISEE sentiment data indicate that some customers are buying to open. Implied volatility is up to 62, from about 58 late Friday.

…If you are interested in more info like this, check out WhatsTrading.com

With the VIX now getting comfortable in the 20s, there has been a fair amount of discussion about just how low we can expect the VIX to go in the next few months.

Back in April, in The New VIX Macro Cycle Picture, I predicted that the VIX will likely not drop below the 25-27 area in the current bull market. That prediction has held up so far, but will almost certainly be tested during the summer months.

Most investors tend to think of the summer season as something of a horse latitudes of sorts for trading, with volume tailing off, portfolio managers on vacation and stocks sometimes set to cruise control. As a result, most people equate summer with lower volatility.

While the VIX does tend to follow a distinct seasonal cycle, the truth of the matter is that we are now at the seasonal cycle low, with volatility historically increasing dramatically from June through October. In fact, over the course of the past two decades the increase in volatility has been highest from June to July, increasing by over 10% (1.82 points.) The pattern is quite distinct in the chart below, which shows composite monthly volatility from January 1990 through last month, using 100 as the series mean.

So…while volatility may indeed trend lower as some of the concerns about the global recession are put to rest in the next few months, lower volatility will have to counter the established seasonal cycle.

For some previous posts on the same subject, try:

• The VIX Annual Cycle (12/24/08)
• A Month By Month Look at the VIX (1/31/07)

[graphic: VIXandMore]

Disclosure: Neutral position in VIX via options at time of writing

He knows his way around options and his blog has some interesting posts and discussions. Here he discusses diagonal backspreads as a way to profit from a market move. He wrote these at the end of March when the market was moving up. It is something to keep in mind if the market ever breaks out of its range and moves down (or up some more).

In Back Spreads Standard and Diagonal he talks about the risks of a credit spread. Say you sell XYZ June 90 and buy XYZ June 100 calls. If XYZ is trading at 92, you can do that for a credit. The risk is that XYZ finishes somewhere between 93, say, and 100 where the calls you sold are more expensive and the calls you bought, the 100s have no value.

In a backspread you sell 10 XYZ June 90s and buy 15 XYZ June 100s. Here you might be able to collect a small premium, which if XYZ goes the wrong way, down, would be your profit. If XYZ moves past 100 those five extra calls give you unlimited upside. Again, if XYZ finishes below 100 your long calls are worthless and your short calls could put you in the hole for $1,000 each.

In the next installment of our saga Back Spreads Standard and Diagonal II he takes as an example the Russell 2000, RUT, which was at 429 at the time. The diagonal constructed is sell 10 May 460 Calls @ 16.70 with a delta = – 363
and buy 16 June 500 Calls @ 11.70 with a delta – 369. So this is delta neutral initially.

This might help you to follow his discussion.

One way to look at this is as a calendar spread of -10 May 460 Calls/ +10 June 460 calls; and a backspread in June -10 June 460 calls / + 16 June 500 calls. We have just added and subtracted the 10 June 460 calls. The calendar spread does well if implied volatility increases and the June backspread does well if the stock rises rapidly to overcome the drag of time decay and decline of implied volatility which usually accompanies rising stock price.

You can triangulate the position the other way too. That is, it is equivalent to a May backspread -10 May 460 Calls / + 16 May 500 Calls and a calendar spread -16 May 500 Calls / +16 June 500 Calls. The backspread wants a move clear through 500 or not to reach 460 and the calendar spread wants an increase in implied volatility.

The last in the series Back Spreads Standard and Diagonal III shows the return graphs with the effect of changes in implied volatility. It doesn’t show the effect of time decay which would give a surface. Worth reading.

The implied volatility of the options yesterday was 200%, now it is down to 100%.

Google

Google was the one that I thought would get pinned. See what happened.

Google Price Chart for Friday 20th March 2009

Google opened the trading day Friday at about 330.5. The highest it got in the day was 332.29 and the lowest it went was about 327. So it stayed within one percent of 330 all day long. So I sold some 330 straddles at 10:00 and bought them back at 3 PM and wasn’t really worried all day long.

If you look at the price chart from Noon to 2:00PM and compare it to the SPY chart below, you see that Google dropped with the rest of the market. While the market, using SPY as a proxy for the whole market, dropped 2.7% in those two hours, Google dropped 1.3% about half the market’s move.

This follows the S&P 500

Autozone, Baidu, and Chicago Mercantile Exchange

In Thursday’s post, I saw that there was a large imbalance in the number of calls and puts set to expire Friday for Autozone, Baidu and the CME. It seemed to me that this would tend to drive their prices down for the day. Since when the call holders sold them for a profit, the market makers would unwind their position and sell stock.

This is the chart for Autozone on Friday 20th March 2009. It is closer to a pin than dropping as I thought it would from the options open interest.

Autozone 20th March 2009

The drop from Noon to 2 PM was 1.25% very similar to Google. And Autozone’s range for the day was from a high of 162 to a low of 157. This is just 1.25% around the strike of 160. Google’s range around 330 was plus or minus one percent. So Autozone was almost as tightly tied to the 160 strike as Google was to the 330 strike.

The question is why was it pinned rather than driven down by the imbalance in the open interest?

This is what Baidu did Friday.

Baidu Price Chart for Friday 20th March 2009

Again, the range for the day was 172.43 to 177.   That is closer than 1.5% of the 175 strike.  So Baidu also traded like a pinned stock rather than one with downward pressure.

This is the CME chart.  It doesn’t have any particular behavior.

Chicago Mercantile Exchange 20th March 2009

So What’s Going On?

You cannot tell what the stock is going to do by looking at the open interest. First, there are a lot of people who are writing calls against their stock to try to earn some income. That will inflate the call open interest. Second, there are spread traders who are long and short puts and calls so that they don’t need to trade out of the options at expiration. Third, there are put writers who are trying to get a better price to buy stock. I read somewhere that that is how Warren Buffett bought most of his Coca Cola stock.

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.

What do you think?

It depends.

If you listen to the folklore, 80 – 90% of options expire worthless. That indicates that it is more profitable to sell options.

On the other hand, like a lottery ticket, an option can pay off big. So you should buy.

What about the risks?

If you buy an option, you can lose the premium you pay so the risk is limited.

If you sell, your risk is unlimited if you sell a call and the stock goes to the moon.

Event Trades

Like the event trade discussed in the last two posts, it depends on what volatility will do and if you expect a spike in price. The event we looked at this week was the Treasury Secretary’s speech on the fiscal stimulus plan. The financial stocks are so volatile now that you can expect large spikes in price often. So we bought.

Another common event is quarterly earnings. As the earnings date approaches there is an increase in uncertainty about what the earnings will be. Implied volatility may increase because there is a chance for a big price move on earnings. That would be dangerous to sell. Earnings are of ten announced after the market closes or before it opens.

If you are short the option and the price of the stock moves overnight against you, the only thing that you can do is sell or buy stock in the after hours market which is illiquid with larger bid ask spreads, or wait until the market opens to get out of your position.

Volatility Trades

As a first pass, compare historical volatility to implied volatility. If implied volatility is much higher than historical volatility, that is a candidate for sale. If implied is much lower than historical, you might want to buy.

Next look at how volatility varies through time. Plot it. Is the historical volatility low now or high? What is the implied volatility of the options. Answering these questions will help you formulate good trades.