Category Archives: Option Basics
The chart below is a two minute chart of the SPY on 04-23-2013. The Associated Press’s Twitter account got hacked and someone tweeted that the White House had been bombed. The Dow Jones Industrial Average dropped 145 points and recovered in about 7 minutes. The SPY is shown below, on a two minute chart the down move was over 30 standard deviations as shown on the red bar. This was an excellent example of the kind of market volatility that one tweet can produce, even though it turned out to be false.
The chart below is Netflix, NFLX, stock after their earnings report yesterday. The up move was over 7 standard deviations as shown on the red bars below the price chart. The line on the bottom is the ratio of the implied volatility to the statistical volatility which has dropped to 204.30 post earnings. We discussed NFLX on my radio show, Ken’s Bulls and Bears report with Jeffrey Dow Jones a couple of months ago.
The long straddle is a strategy that can be employed prior to the release of a significant news announcement. One time might be when government economic reports like the GDP or unemployment numbers are about to be released.
The way the strategy works is pretty simple. We know that there is going to be some news that could affect the market. We don’t know what’s in the news or how the market will react. To be prepared for a big market move in either direction we decide to purchase a long straddle on the SPY which is the ETF that represents the S&P 500 index.
To purchase a straddle you buy an equal number of calls and puts at the same strike price which is at the money. At the time of this writing the SPY is at 140.96 so I have illustrated a 141 straddle. I am showing the Jan 19th expiration. The straddle will cost $5.00 to purchase and that is the maximum risk. If held until expiration the break even points are $146 and $136.
With the fiscal cliff talks going on congress could make an announcement anytime. Right now the house is planning to convene on Sunday, so they could have an announcement prior to the market open on Monday. A long straddle purchased before the weekend could be profitable if the market has a big gap open on Monday after congress meets.
If the straddle is held longer than a couple of days, the investor can employ a “gamma scalping” strategy to offset the option decay as measured by the position’s theta.
Below is an illustration of the P&L graph for the SPY Jan 19, 141 straddle.
Google’s third quarter earnings were released early today. It was a big miss for Google on profits. The stock opened today at $755.54, hit a high of $759.42, then dropped all the way to a low of $676.00 before bouncing a little and closing at $695.00. It will be interesting to see what tomorrow brings. Below is a chart showing the big price move measured in standard deviations. Today’s drop was over eight standard deviations!
Earnings Dual Calendar
The dual calendar spread consists of a put calendar spread and a call calendar spread. It can be put on for a net credit or a net debit. A debit dual calendar spread can be an effective strategy around earnings time. We’ll call it an earnings dual calendar and here’s how it works. We want to be long the options that are in the reporting month because we are forecasting a rise in implied volatility in the option price until the report comes out, and then the implied volatility will fall rapidly. We’ll be short the contracts that will expire before the earnings release because we know that their implied volatility will drop with their expiration date. He’s an actual example from the time of this writing. This is not a trade recommendation. STI, Sun Trust Bank will report earnings on Monday October 22nd, 2012. We anticipate that the implied volatility of the November options will remain elevated until the earnings announcement. We forecast that the implied volatility of the October options that expire on October 20th, before the earnings announcement will collapse by the expiration date. We can put this trade on in the first week of October and plan to hold it until the October expiration on October 20th. Here are some of the key data points;
Size Exp Strike Put/Call Price IV Theta Delta
+1 Nov 17 28 Put 0.93 31.27% -1.34 -39.72
+1 Nov 17 29 Call 1.00 29.45% -1.32 47.22
-1 Oct 20 28 Put -0.39 27.75% +1.85 34.31
-1 Oct 20 29 Call -0.46 25.52% +1.85 -41.91
So, the net debit is $108 which is also the maximum risk. For a ten contract position that would be $1080. The theta is $1.01 which means that for each contract you’ll earn the decay of $1.01 per day, for a ten contract position that amounts to just over $10 per day in option decay. The net delta is -0.10 which is essentially delta neutral. The plan is to close the position on the day of the first expiration before the earnings come out for a net debit greater than $1.08. If the underlying makes a substantial price movement the position will take on some delta and some form of a gamma scalping strategy can be applied to make the position delta neutral again.