GS - an alternative trade to Strangle or Straddle

I like to consider an alternative to the strangle trade on GS proposed by Joseph.

I have entered a ratio put backspread for GS for 185/180

It is a very speculative trade. There is little time to react after the earnings event. It will suffer greatly from time decay. It is a contrarian trade as it is against the general sentiment of the market.

Thus this will be only a paper trade for education purpose to learn how a short term ratio spread reacts to an earning event.

In essence, you want the stock to move. If the stock does not move after the event, both the straddle / strangle and ratio back spread will be in a losing position.

In this case, I want to use the example of a put ratio backspread. My direction is bearish bias. A similar trade can be structured for a bullish bias trade using a call ratio backspread. You need to decide your bias before deciding on the trade.

The trade can be structured in 2 time frames:

1. Short time frame – if you just want to capitalize on the reaction to a specific event and then get out.
2. Long time frame - if you are longer term bearish and believe that the stock will break down eventually.

For this trade, I will be placing a very short time frame trade i.e. Oct 185/180 back spread. I have only a few days to react to the trade.



Considerations:

· Earnings for GS is on 10/15 – it is confirmed

· GS seems to be hitting a top. But the whole market is bullish. Longer term, I believe the GS has hit a short term top. It will react negatively to its earnings. The trade has gone up too fast and too much. I will structure the trade such that any correction more than 10%, trade will be profitable.

· It is ideal time to place the trade as VIX is at record low. There is no fear in the market right now. As we approach the peak of the earning season, I expect volatility to pick up in the next 10 days

· I am not structuring a long time frame ratio put spread. It will be more expensive and thus return will be lower. The advantage however, there will be more more time to work if we use a longer time frame like 3-4 months. It will be a lot more expensive.



Trade:

Put ratio backspread for 185/180

· BTO 2X Oct 180 Put for 1.94
· STO 1X Oct 185 Put for 3.75

Debit: 0.13

This trade is also Bull Put + Protective Put or ( 3.76-1.94)+ 1.94 = 0.13


RISK:

Risk in Put ratio backspread:

· Bull put risk = difference in strikes ( 185-180) – bull put credit ( 3.75 – 1.94 ) = 5 – 1.81 = 3.19
· Protective Put risk = debit of protective put = 1.94

Maximum Risk ( loss ) = 3.19 +1.94 = 5.13





From the chart:

· Stock has potential to hit 204.75 – the next fin. retracement level at 78.6%
· On the reverse, MACD is peaking. I believe the trade may move in my direction.
· I will bet that GS will move down after the earnings event. If the stock moves up after earnings, my risk is limited to 0.13 debit. If I am right, the profit is high. In addition, I am convinced technically the stock has a good probability to move down despite the bullishness of the market. It is a contrarian bet.
· Interestingly, GS was downgraded this morning before the earnings event! This adds support to my bearish bias

Breakeven Calculations


· Theoretical Lower B/E : Srike of PP minus the risk of the entire trade
( 180 – 5.13 ) = 174.87

· Theoretical Upper B/E: Strike of the Short Put – net credit of the entire trade
( 185 – net credit of entire trade ) -= 185+.13 = 185.13

If stock rises above 185 after earnings, the trade will lose 0.13

If stock goes down and crosses 175, the bull put will expire worthless and PP will make money. This is not a bad probability.

Worst scenario – if the stock does not move and stay at 180, the trade will hit its maximum risk of 5.13

PE:

If trade moves bearish after earnings, take profit. If very bearish, buy another long put.

SE:

· Close the trade a 20% to 30% net loss within 4 days after earnings event. Do not wait as this is a very short term trade.

· Roll the entire trade further out in time for trade with short time frame. If you believe that you are still bearish, then roll it out ( will lose some credit and thus not preferable unless the market shows some signs of exhaustion. )

· Add short positions against the additional long option - not applicable as this is a very short term trade.

· If GS shows some support after the earnings event, we may want to take assignment of the stock and collar it. Sell the Long puts. Add a longer term put and BTO a SC.