Option Investor
Trader's Corner

Searching for Play Candidates

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Are you feeling restless and on the lookout for new play candidates? Or, are you, like me, driving yourself to vary the types of trades that you employ in the ever-present search to diversify risks?

The reasons for seeking new trades or types of plays vary. So do the methods that traders employ to find those trades. I don't like varying my trades. I like to be familiar with the underlying and the specific options strategy, so familiar that I can trade it under any kind of conditions, such as when my granddaughter has been rushed to the hospital again or when I'm experiencing spring fever and really can't be bothered to concentrate. However, one type of underlying with one type of options strategy creates a portfolio with risk setups that aren't balanced, and that's not good in some environments. So, this year, I'm forcing myself away from my comfort zone.

I'm inviting you to look over my shoulder as I search for specific types of play candidates in my year-long trading goal of diversifying risks away from a trading account full of condors.

As some of you may know, condors tend to suffer in when volatility rises. If you didn't know it before, many have had reason to learn that lesson this summer. Among the Greeks of option pricing, vega measures volatility risks, and condors have negative vegas. That means spot profit/loss values in an account full of condors drop as volatilities rise and rise as volatilities decrease.

Straddles show a much different profile. The straddle involves the purchase of a call and a put with the same strike and expiration date. If those calls and puts are at-the-money ones, the delta of the total position is near zero and the vega is positive. This means that, until the price moves far enough away from the position, price action doesn't tend to help the total position, so traders want a big price move. In addition, the positive vega means that the position benefits if the volatility rises, because the position's value is moving with the vega.

Delta stays neutral only while prices sit still, however. The trade can be profitable if price moves far enough that one of the options gains far more than the other loses. The position can also benefit from a rise in volatility. The risk in the position is only and totally the debit paid to enter it. One shouldn't ignore an in-the-money options position at expiration, of course, unless one wants to buy or put the underlying, so plan to close out the position the day of if not before option expiration.

Condors, of course, have a terrible risk/reward profile.

There's a catch with straddles, however. Theta is negative for straddles. That means that the position will lose value each day without movement or a rise in volatility. As option expiration approaches, that theta will rise for ATM positions, and the theta-related decay will accelerate. The closer an option is to expiration, the faster price and volatility have to change to offset that theta-related decay.

For me, there's another catch. Although I tend to be a patient trader, I'm not when I'm trading straddles. I don't know why, but I keep trying to micro-manage the position and trade in and out of one leg or the other. For that reason, I abandoned straddles some time ago for my personal trades, but they're a trade I needed to add back to my repertoire if I am going to vary my risks appropriately.

Where to start? Since this trade benefits from a move in price or a rise in volatility, I decided to start my search by looking for a security with implied volatilities below historical volatilities. My thought was that, since implied volatilities tend to revert sooner or later to their historical volatilities, this might set up the possibility of a rise in volatility, if not promising it. On my brokerage page, this search is done by screening for stocks with low IV/HV ratios.

In addition, I wanted other parameters met. I wanted a stock with an average daily volume of above 1,000,000 and with a price above $50.00. I wanted options with decent open interest, too. The object of these parameters was to insure that there was enough liquidity to easily enter and exit positions. As will be shown, my search for enough liquidity didn't exactly turn out to be realized in actuality.

The search, accomplished on August 3, 2008, turned up several candidates, but I zeroed in on Barr Pharmaceuticals (BRL). BRL's three-month average daily volume was 3,323,430, according to Yahoo's finance pages. However, with BRL at 66.44 as of the close on Friday, August 1, BRL's SEP 65 call and put, the nearest to ATM strikes, had open interest of only 14 and 189, respectively. I prefer to get far enough from option expiration that theta-related decay isn't accelerating so fast, but that OI showed me that I wasn't going to find much liquidity in the September options. I probably wouldn't be able to get between the bid and the ask on the combined position.

The August versions had open interest of 5,683 and 299, respectively. Bid x ask for the SEP straddle would be 3.15 x 4.90, and for the AUG, 2.45 x 3.00. SEP option expiration was 47 days away; August's, 12. Looking at volatilities for the SEP and AUG 65 calls showed about a three-point skew, with the volatility for the AUG about three points above that for SEP.

That skew in volatility told me something was expected to happen in August. Since it was earnings season, I thought I knew what that "something" might be: earnings. In fact, a search of Yahoo's finance pages turned up the information that BRL would report on August 7.

That threw a wrinkle into the theory that volatilities might rise, because they tend to do the opposite after earnings. BRL's AUG options would stop trading six trading sessions after the day it reports earnings. What about price? What has typically happened with BRL after earnings, I wondered. Does it tend to move big enough to offset any decline in volatility after earnings?

Action near earnings reports:

05/08/08: On 5/07/08, the day before earnings, BRL closed at $49.65, and, by 5/08/08, the day of earnings, had closed at $38.10, a 23 percent decline.

02/28/08: BRL closed at $48.35, and, by 3/03/08, 2 trading days later, had closed at $45.67, a 5.5 percent decline

11/08/07: BRL closed at $56.68 and, by 11/12/08, 3 trading days later, closed at $51.76, an 8.6 percent decline.

08/08/07: BRL closed at $55.00, and by 8/16, 6 trading days later, closed at $52.59, a 4.4 percent decline.

BRL, then, had a history of moving at least 4.4 percent within six trading days after earnings. Moreover, it had a history of moving down after earnings, which would tend to beef up the volatility rather than decrease it. With BRL at $66.44 as of 08/03, a 4.4 percent move, the minimal move after the last four earnings reports, would be a $2.92 move. With the bid x ask of the AUG 65 straddle at 2.45 x 3.00, as already noted, there's the possibility of a move big enough to bring that straddle into profitability. However, any move would have to be a fast one to overcome the accelerated theta-related decay that close to AUG option expiration.

Did the chart shed any light on the situation? A glance at the point-and-figure chart showed that BRL had a revised bullish price objective of $117.00, but it's long climb up that began in July had yet to see its first three-box reversal, something that may have been long overdue.

The daily chart showed the possibility of a big move after the AUG earnings announcement, too, with some caveats.

Annotated Daily Chart of BRL as of 8/03/08:

The weekly Keltner chart provided possible upside and downside targets as of 8/03/08.

Annotated Weekly Keltner Chart of BRL as of 8/03/08:

The weekly Keltner chart showed the possibility of a post-earnings move big enough to benefit the straddle: down toward $60.24 or up toward $70.00. However, moves on a weekly chart might not unfold quickly enough to turn a straddle profitable within a matter of days.

An FOMC decision was due on Tuesday, August 5, two days before BRL was due to report. If equities moved big in anticipation of that decision, BRL could be carried along. There existed, then, the possibility of a big pre-report or post-report move, especially if the FOMC decision resulted in a strong downdraft that might carry many equities lower, regardless of expectations.

By Tuesday afternoon, just prior to the FOMC decision, premiums had changed slightly. The AUG 65 straddle was priced at 2.45 x 2.8. My brokerage page pulled up the following Profit & Loss Chart with the blue line and P/L calculations showing profit and loss at expiration and the red line showing projected profit and loss on August 8, one day after the earnings reports.

Profit & Loss Chart for BRL AUG 65 Straddle:

The input for this trade was a debit of $2.80, the full ask at the time. I used that input in case it turned out to be difficult to get between the bid and the ask on BRL, which it in fact turned out to be. However, at 2:19 pm on 8/05/08, I was filled for 2 contracts each at $2.70 for a total debit of $480.95 once commissions were added. I use fewer than 6 contracts when I'm testing a strategy that I haven't used recently.

Trade Confirmation:

My intention was to seek a mere 10 percent gain on the position since this was a test run only, but I wanted 10 percent after commissions. I set my profit limit at $3.15. For the purposes of this test, I would accept a 25 percent loss.

BRL reported, and all my calculations about typical moves after earnings were for naught. BRL didn't budge. Much.

On the day on which it had reported, BRL had jogged up to a high of $68.15. However, when it did so, it was hitting what I know can be significant Keltner resistance that was then at about $67.90 on 15-minute closes. In addition, the weekend and its deleterious effect on AUG options was quickly approaching. I started looking for an exit.

By the afternoon of Aug 8, the straddle had bids and asks that indicated that I could exit for near my 15 percent profit, at least, by coming between the bid and ask. However, when I tried to exit, I found that I couldn't exit the trade anywhere near the midpoint between them. I began trying to exit at 2:36 pm, asking for a credit of $3.10. I wasn't filled until 3:10 pm, by which time I'd gradually lowered the order to $2.85, only a nickel above the bid, if I'm remembering correctly.

Trade Confirmation to Close:

Although the $2.85 credit was more than the $2.70 debit I paid to enter the position, commissions took a bite out of my takings, and I ended up making a paltry $34.09 or 7.01 percent gain on my original investment.

BRL never again gave me the chance to exit at even that much until option expiration Friday, when it bumped up to a high of $68.16 and then settled in near $68.00 for a few hours. At noon of that day, the bid x ask for the $65 call was 3.00 x 3.20, so I could have exited for $3.00. However, my stop loss likely would have been hit long before that, when BRL traded down to a low of $66.45 on 8/13 before it began soaring again. I made an educated guess the week before opex and attempted to exit at slightly less than my original profit target, before theta-related decay accelerated. By then it had become obvious that BRL wasn't behaving as it usually did after earnings, one of the reasons upon which the trade had been predicated. I ended up having to inch down the credit I was asking until the profit was much less than anticipated, but it was a profit. And, I left the straddle alone until the exit, not micromanaging by trading in and out of each leg.

What did I learn? I learned that, yes, I can abstain from micromanaging the position. I think, given BRL's typical behavior after earnings, its low IV with respect to historical volatilities and its precarious perch far above a gap that just begged to be filled, it was a decent attempt at a trade. However, I should have paid more attention to BRL's tendency to consolidation for long periods when it's not making a big move--a sort of conundrum in its behavior. Also, the difficulty the first day in getting close to the midpoint of the bid and ask and the total inability to get between them when exiting convinced me that I don't want to dabble in BRL options.

Will I try straddles again? Certainly, but not on BRL.

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