We’re starting a new occasional series where we look at a recent trade and analyze what went into the pricing and how it played out. We think this will be useful as an educational tool to readers. It take most people about a year of working on an options desk before alot of the mystery behind how options price and move become second nature. But even after years of trading some things about options can remain difficult to price and the education is always ongoing. Looking back at how a trade played is always a great exercise in that learning process.
For instance with the PCLN trade the other day, one of the things we were able to do was to look at historical vols in the April part of the trade and roughly determine what the traders would lower it to following the earnings. We also noticed how much higher the options were implying daily moves than what has been the actual price movement of the stock over time. The trade didn’t work out great because PCLN kept running in the morning, but we’d do that trade all day long, very little risk, very big potential reward. We’ll be doing more of these slightly more sophisticated trades on the site from now on. Especially with this volatility crush happening since December. Trade structures have to be a little more clever in order to make money in a low vol environment.
So how did we determine what would happen to volatilities and premium in the trade following earnings?
The vega of an option is the change in price for a one point move in the implied volatility. So the percentage move in the option is dependent on its vega. This sounds more complicated than it is. The best way to think of it is an option that is in the money, so has more intrinsic value will lose less of a % of its total value when implied volatility is lowered. An ATM and OTM option would lose more. Here’s the explanation of vega from Kristen: http://staging.staging.riskreversal.com/education/#vega To know the exact change you need to know the vega, however, you can estimate it in a situation like the PCLN trade by saying, we think vol will come in 25%, so the premium of an OTM trade structure in that month will come in roughly the same.
What we were looking for was a trade that took advantage of the high volatilities in the options in the front month, but within a structure that protected us from big losses if there was an outsized move. We were also drawn to the stock because the thinking that high dollar stocks often underperform expected moves implied by the volatility. We wanted to place a bet that the stock underperformed the implied move, but also that the difference in the total premium represented by an ATM straddle in the near term at extremely high vol was more than enough to make up for the loss of total premium in an OTM straddle in a farther out month with less inflated volatilities.
So what does that structure look like from a position strategy. Kristen did a back of the napkin analysis (almost literally, she drew it out on paper) of how it would look at March expiration as two component positions:
One way to think about the PCLN trade at Mar 2 expiration:
(Graph drawn by me is not remotely consistent scale, nor are the line angles correct or consistent.)
Looking at the graph of the short straddle and long strangle together, we can add the the P&L at each point. So for ease of numbers let’s say we sold the Mar 2 weekly straddle at $45 and bought the Apr strangle for $30, net receiving $15 for the trade. At Mar 2 expiration, if the stock is is at $595 then you own the strangle for net $15. Between $580 (595 – 15) and $610 (595 + 15) you have received money to own the strangle. Between $580 and $550 or $610 to $640 you own the strangle for less than $30 and anything above $550 or $640 you own the strangle for $30.
The April implied volatility is trading under 40 which is on the low side for this stock considering earnings and its relationship to the weeklies. Therefore we don’t mind owning the April strangle for $30 which is our worst case scenario. And our expected scenario, which is stock does not move beyond the implied move, means we are buying the strangle for less than $30 up to a $15 credit. So this is a fairly low risk volatility play where we want to sell the earnings vol pump without the risk of an outright straddle sale. We are taking advantage of the volatility skew between the earnings week and April.
This way of thinking about the trade and what it becomes after the front month expires is helpful. You are selling a straddle to finance a strangle. Of course, there are other ways to look at the trade and every trader thinks about these things differently. What I was focusing on was what it would look like the next morning making assumptions about implied moves, differences in volatility between months and likely outcomes in the lowering of vol following the event by the market makers.
Ultimately the trade didn’t work out as we hoped and we took it off the next morning for a small gain. After the move, the position basically became a very short delta position and we didn’t feel like sticking around and being dependent on sellers entering or worrying about a short squeeze.
As I said we’ll be trading alot more of these more complicated structures in the future on the site to take advantage of the changed volatility environment.