A straddle / Strangle is used when there is a fixed event that will move the stock up or down. The regular event is the earning announcement. It occurs every quarter. Other big movers are drugs awaiting FDA approval or a new product introduction, a big political event or pending merger or acquisition.
If the stock does not move after the event, the trade will lose money on this trade. It is an expensive trade. Besides suffering from time decay, your trade is negatively affected by the volatility crush after the event. Normally, IV will be high just before you enter the trade. Volatility crush will kill the trade without mercy. If you are wrong, you can lose up to 80% of the value. But if you are right, the upside is unlimited.
It is classified as a "vegas" trade. It is a more or less like a bet on a lottery.
But it does not have to be this way. Trade will lose a little money if the trend remains stagnant. Most of the time it can end with a profit with some minor adjustments.
The example given will show how to have high probability of winning in all directions.
It is done by cushioning the volatility. The time decay is minimized by acting quickly to close or adjust the trade once the results of the event is known.
The trade consists of a strangle and a collar.
Similar to on of the criteria of choosing a trade for strangle / straddle, you want a high volatility stock that will move after an event.
Similar to on of the criteria of choosing a trade for strangle / straddle, you want a high volatility stock that will move after an event.
FSLR is used as a case study below.
Background
FSLR is poised to announce earnings at the end of the month. Almost without fail, the stock moves after earnings.The stock will also move even before the earnings.
With the big run in the last few weeks, there is even a higher probability that the stock will move markedly after the earnings call.
Short ratio is currently very high at 30.37%.
Personally, I am not convinced of the competitive edge in the stock. The main competitive edge is the subsidy from the German government. This is not a sustainable edge. Their technology and cost positions are falling behind.
But again, I am not arguing with the fundamentals. Technically, the stock is moving bullish. Thus, I expect some big moves before or after earnings as emotions are running high. IV is above average.
Trade:
Trade was entered on Feb 10th - BTO 5 FSLR = 155.79
- STO 5 Jan 12 165 = 19.75
- BTO 10 Feb 155 put = 3.55 ( very short term put. Can also use March 155 )
- STO March 155 Call = 9.9
Cost = 153.04 ( 155.79-19.75+3.55*2+9.9)
The trade will make money if it is bullish or bearish. Anything about >5 % the trade will be profitable. The decision can be to close the trade and take profit or convert the trade to a CC if still bullish on the direction.
You can also close one leg of the Call or Put to maximize the unlimited potential if the trend justify.
In the even of a low probability that the stock does not move after the earning call, you can always close all the legs and Roll down the LEAP SC to make it a short term covered call. You should be able to regain all the small losses and make some small profit. For these adjustments, you do the following:
- Sell the LC and take some loss
- Roll the LEAP SC down to a nearer strike and take some profit. Add a 1 to 2 months expiration
ATM, ITM or NTM SC to create a new Covered call.
You now have a covered call. You can manage it to profitability with relative ease over time.
Closing the trade
FSLR went up > 6% to a high of 167.4 the next day.
I can hold the stock and wait till earnings are announced.
But I decide to close the trade and take profit although I believe it will make more money if I am right after earnings.. But I decide to be conservative and take the profit first. I have similar trades on NVDA and RIMM waiting for results.
STC Stock = 166.816 Profit = 11.02STC March 155 C = 17.22 Profit = 7.32
BTC Jan 2012 165 SC = 27.25 Loss = -7.5
STC Feb 155 P = .99 Loss = -5..12 ( 2 puts )
Net Profit = 5.12 or 3.74 % for 1 day
This is nice gain given the short duration and a relatively safe trade.
Posts
Very risky kind of trade
ReplyDeleteSantosh,
ReplyDeleteLet us know why you feel it is risky?
The puts and SC cushion any big down move.
The stock and LC will make good money on huge upside move. It will more than compensate the loss on the puts and SC.
If the stock is stagnant - you will lose a little money. But this can be offset by some adjustments over 1-2 months.
I have paper traded on 3 stocks - took profit on one FSLR. For NVDA and RIMM, I can see from day to day, the account does not fluctuate a lot on net profit. When it moves, I will make money.
One note is that you will need to take action once the anticipated move takes place or the trade will lose money because of time decay of the long options.