Searching for Victims

If like me you were a Monty Python addict back in the days then you are probably familiar with the phrase ‘And now for something completely different’. As you probably know we’re in the midst of Q2 earnings season right now, and Jay The Executioner in collaboration with yours truly has been on the hunt for potential IV crush victims.

 

crushing_tank-1000x622A tragic victim of Operation Volatility Crush.

Photo via gdefon.ru

 

To a seasoned option trader earnings season is tantamount to Christmas, but four times a year. Because just like moths are invariably drawn to the flickering lights of a burning flame, retail traders can’t help themselves but accumulate overpriced options in hopes of guessing the resolution of earnings reports.

And they mostly think of options in a 1-dimensional way – and that is limited to only price variation: up or down. However, options happen to be multi-dimensional derivatives which require multi-dimensional thinking.

 

multi-dimensionalThere’s more than one dimension to options

Image via dreamstime.com

 

Sure, that all sounds really easy Mole. Let me check back with you once I get my PhD in quantum physics then, alright? No worries – we’ll get you there one step at a time. For starters if you haven’t already then I suggest you catch up on the first three installments of our option tutorial series. It’ll get you up to speed on basic option theory, the greeks, and most recently I covered the various benefits of vertical spreads in comparison with naked options.

 

1-option_vega_expirationTime to expiration vs. option vega. Vega shows the the change in the price of an option for every 1% change in underlying volatility – click to enlarge.

 

One of the advantages I mentioned was reduced exposure to theta burn. We also know from the tutorial covering the Greeks that volatility does affect options quite a bit. If you look at the graph above then you see that vega is highest in options that have more extrinsic (i.e. time) value.

Therefore an April option with a strike at $50 has a lot less vega than a June option with the same $50 strike. In general the rule is that the more time remains to option expiration, the higher the vega will be. You can also see in the graph above that longer term options show a vega peak a bit OTM (out of the money) whereas the near term ones show a vega peak near the ATM (at the money) point. Just keep this at the back of your mind for now.

 

2-option_theta_volatility1Volatility and its impact on option theta. Theta measures an option’s sensitivity to time decay – click to enlarge.

 

The second vega related graph I posted was this one which depicts how a rise in volatility affects the extrinsic value of an option in general. It very distinctly depicts the mechanism that serves as the basis for the phenomenon we call vega crush. And this is how it works:

 

Fear Multiplied by Time Equals Volatility

During earnings season, volatility on front month options often increases significantly as investors/traders anticipate more volatility due to uncertainty about the companies represented by the stocks they are trading. That increases what is called SKEW on the options smile – again a topic we covered here in the past but will revisit again in the near future.

For now just remember when it comes to derivatives like options, the game is all about anticipation of price, time, and volatility. We are banking on the fact that the latter, volatility, will be grossly inflated. In fact when selecting our symbols Jay and I specifically were looking for large differences in historical vs. implied volatility. If it’s overpriced – we want to sell it.

 

When the Cat is Out of the Bag

Once the earnings report is out, price has either moved up, down, or not at all. Attempting to predict one of those three options either requires insider knowledge (illegal, cough, cough) or a crystal ball (not sure if they are illegal).

There is one component of options however that is highly predictable and that is volatility. And in almost all cases, except perhaps the release of extremely disastrous news about the company, is the direction vega will take after the earnings announcement, and that is down.

So here is an idea – why not try to trade vega instead of price? Well, indeed – why not?

 

Learning How to Swim

The inimitable Bruce Lee is credited with saying that “you can’t learn how to swim standing at the beach”. So I’m just going to throw you all into the proverbial water here and see what happens. I was originally planning on posting option related setups after at least having covered credit spreads and condors but I think you know enough to be dangerous and perhaps play along just paper trading for the moment.

There are probably a myriad ways of how to play vega crush but we’ll introduce two of them today. The first one is a double calendar spread and the second is a bastardized version of an iron condor of which I don’t know whether it actually has a name. I have therefore decided to call it a ‘limping condor’.

Both take advantage of calendar spreads which are also known as horizontal spreads as the vertical option chains of various expiration months used to be listed horizontally on a big board back in the olden days.

We haven’t covered calendar spreads yet but will do so in the near future – for now just know that calendar spreads are either aimed at exploiting differences in time value (measured by theta) or volatility (measured by vega), which implicitly affects theta.

 

The Idea and the Victims

Both strategies will attempt to sell inflated vega in front week options and at the same time limit risk by buying back front month options which we expect to be less affected by vega crush. That’s a more short term variation on the same popular theme which involves selling front month options and buying more longer term options, e.g. contracts expiring three to six months out.

Jay and I have parsed a number of symbols which expire this week and selected Facebook (FB) and First Solar (FSLR) as our first two victims. For the purposes of exploiting IV crush we will be selling weekly April options which expire in a few days and at the same time buy back May options which expire in about a month from now.

So those are just about to fall off the plate in the theta department. Clearly we are not planning to hold either strike for very long. The time window of both of these strategies is one day to a few days – the maximum is Friday when the April options expire.

 

Symbol: FB
Strategy: Double Calendar
Idea: Sell inflated pre-earnings IV.
When To Enter: Before 4/27 earnings announcement.

When To Exit: After earnings announcement OR we hold through expiration if there is little IV movement.

 

Strategy Details:

 

3-table-A-FB strategyDetails of FB vega crush strategy

Initial outlay: $149 (net debit)
Maximum risk: $154 at a price of $75.60 on day 26th Apr 2016
Maximum return: $304 at a price of $118 at expiry
Break/evens at expiry: $126.20, $95.50
Considerations: We are betting on a significant decrease in front month IV, which is extremely elevated compared to recent levels of realized volatility (see the historical IV chart comparison below). The front month straddle in this case is expecting a roughly $8 move, which is where we have set our short strikes.

We looked at the limping condor here as well, but the double calendar made more sense as the initial outlay is almost identical to max risk. Max return meanwhile is double the outlay. Keep in mind, one doesn’t start losing money on this trade until the stock climbs above $126.2 or falls below $95.50 – a rather unlikely scenario by week’s end.

 

4-FB_historical_IVThe difference in historical vs. implied volatility in FB right now is about 20%. Juicy.

 

Symbol: FSLR
Strategy: Limping Condor
Idea: Sell inflated pre-earnings IV.
When To Enter: Before 4/27 earnings announcement.

When To Exit: After earnings announcement OR we hold through expiration if there is little IV movement.

 

Strategy details:

 

5-table-B-FSLR strategyDetails of FSLR vega crush strategy

 

Initial outlay: $34 (net debit)
Maximum risk: $236  at a price of $36.55 on day 26th Apr 2016
Maximum return: $221 at a price of $66.50 at expiry
Break/evens at expiry: $71.45, $51.60

Considerations: We are betting on a significant decrease in front month IV, which is extremely elevated compared to recent levels of realized vol (again see the graph below). The front month straddle suggest the stock will move less than $6 in either direction by the end of the week.

Given that scenario, selling the wings makes perfect sense at these price levels. We also priced out a double calendar but felt low cost of the initial outlay made this Limping Condor a better trade candidate.

 

6-FSLR_historical_IVFSLR historical vs. implied volatility – here we apparently also have a ~20% delta between historical and implied volatility. That is what we want to see and that is what we are selling.

 

Theory Vs. Reality

Nothing in trading is ever a sure bet, and that prime directive also extends to the world of option trading. A lot can happen between now and expiration but condors and calendar spreads in general are known to be high probability but low return strategies, if selected and managed properly.

Those returns however can increase quite significantly when taking advantage of volatility changes, so let’s just see what happens. Jay the Options Executioner will also be monitoring the board today, so if you have related questions blast away! [ed note: the discussion can be followed/ joined here]. We’ll be trading these setups on our end and will then report back with the results – either the day after the earnings announcement or when the weekly April options expire.

 

Charts by: IVolatility.com, Evil Speculator

 

Chart captions by PT, except captions on historical vola charts

 

Originally published as “Let’s Crush Some Volatility” at evilspeculator.com.

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • As the Madness Turns
      A Growing Gap The first quarter of 2019 is over and done.  But before we say good riddance.  Some reflection is in order.  To this we offer two discrete metrics.  Gross domestic product and government debt.   US nominal GDP vs total federal debt (in millions of USD) – government debt has exceeded  total economic output for the first time in Q4 2012 and since then its relative growth trajectory has increased – and it seems the gap is set to widen further....
  • A Trip Down Memory Lane – 1928-1929 vs. 2018-2019
      Boom Times Compared It has become abundantly clear by now that the late 2018 swoon was not yet the beginning of the end of the stock market bubble – at least not right away. While money supply growth continues to decelerate, the technical underpinnings of the rally from the late December low were actually quite strong – in particular, new highs in the cumulative NYSE A/D line indicate that it was broad-based.   Cumulative NYSE A/D line vs. SPX – normally the A/D line...
  • Long Term Stock Market Sentiment Remains as Lopsided as Ever 
      Investors are Oblivious to the Market's Downside Potential This is a brief update on a number of sentiment/positioning indicators we have frequently discussed in these pages in the past. In this missive our focus is exclusively on indicators that are of medium to long-term relevance to prospective stock market returns. Such indicators are not really useful for the purpose of market timing -  instead they are telling us something about the likely duration and severity of the bust that...
  • Debt Growth and Capital Consumption - Precious Metals Supply and Demand
      A Worrisome Trend If you read gold analysis much, you will come across two ideas. One, inflation so-called (rising consumer prices) is not only running much higher than the official statistic, but is about to really start skyrocketing. Two, buy gold because gold will hedge it. That is, the price of gold will go up as fast, or faster, than the price of gold.   CPI monthly since 1914, annualized rate of change. In recent years CPI was relatively tame despite a vast increase in the...
  • Unsolicited Advice to Fed Chair Powell
      Unsolicited Advice to Fed Chair Powell American businesses over the past decade have taken a most unsettling turn.  According to research from the Securities Industry and Financial Markets Association, as of November 2018, non-financial corporate debt has grown to more than $9.1 trillion [ed note: this number refers to securitized debt and business loans, other corporate liabilities would add an additional $11 trillion for a total of $20.5 trillion].   US non-financial corporate...
  • The Liquidity Drought Gets Worse
      Money Supply Growth Continues to Falter Ostensibly the stock market has rallied because the Fed promised to maintain an easy monetary policy. To be sure, interest rate hikes have been put on hold for the time being and the balance sheet contraction (a.k.a.“quantitative tightening”) will be terminated much earlier than originally envisaged. And yet, the year-on-year growth rate of the true broad money supply keeps declining noticeably.   The year-on-year growth rates of...
  • What Were They Thinking?
      Learning From Other People's Mistakes is Cheaper One benefit of hindsight is that it imparts a cheap superiority over the past blunders of others.  We certainly make more mistakes than we’d care to admit.  Why not look down our nose and acquire some lessons learned from the mistakes of others?   Bitcoin, weekly. The late 2017 peak is completely obvious in hindsight... [PT]   A simple record of the collective delusions from the past can be quickly garnered from...
  • The Gold-Silver Ratio Continues to Rise - Precious Metals Supply and Demand
      Is Silver Hard of Hearing? The price of gold inched down, but the price of silver footed down (if we may be permitted a little humor that may not make sense to metric system people). For the gold-silver ratio to be this high, it means one of two things. It could be that speculators are avoiding the monetary metals and metal stackers are depressed. Or that something is going on in the economy, to drive demand for the metals in different directions.   As a rule the gold silver...
  • The Effect of Earnings Season on Seasonal Price Patterns
      Earnings Lottery Shareholders are are probably asking themselves every quarter how the earnings of companies in their portfolios will turn out. Whether they will beat or miss analyst expectations often seems akin to a lottery.   The beatings will continue until morale improves... [PT]   However, what is not akin to a lottery are the seasonal trends of corporate earnings and stock prices. Thus breweries will usually report stronger quarterly earnings after the...
  • Bankrupting Coffee Shops - Precious Metals Supply and Demand
      Coffee, Milk and Gold Last week was holiday-shorted due to Good Friday (it’s not an official holiday in the US, but it is in the UK. And this week’s report is a day late due to Easter Monday). The price of gold dropped $15, but the price of silver rose ¢4. Perhaps silver traders got word that we are paying interest on silver, which gives people a reason to hold silver? J   A silver bar plus interest...  [PT]   The discussion in the opening essay [which can be...
  • Kashmir: The Constant Conflict
      Threats of Nuclear War On February 26, 2019, the Indian Air Force, for the first time since 1971, conducted a raid inside Pakistan, and allegedly hit a terrorist training camp, killing more than 250 terrorists. Pakistan showed photographs of damage to a tree or two. According to Pakistani officials, no one died and no infrastructure was damaged.   Mirage 2000 warplane of the Indian Air Force in medias res. [PT] Photo credit: hindustantimes.com   It is hard to...

Support Acting Man

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!