Thanks to Jon Najarian and the OptionMonster crew for a fun hour talking shop.
Webinar 2/13/13: Trading Tech in 2013 with Options
The most attractive uses for equity options for the average investor are; Risk Management, Yield Enhancement, and Leverage. In this webinar, we plan to touch on all 3 points.
Our Process: Develop Directional or Vol thesis using the following inputs:
a. Implied move vs historical
b. Fundamentals; valuation, product cycles, competitive pressures, corporate action etc
c. Sentiment; analyst ratings, price targets, short interest, change in estimates
d. Price action and technicals, have a view on where the stock has been and where the charts suggest it could be going.
e. Volatility, get a sense for what base vol should be in the name, and where it is likely to settle after the event, this is tied to the implied move, but when evaluating different structures and expirations to express the view.
Once Directional thesis and vol view established, arrive at the the most cost effective way to express the view. In some instances we will arrive at the conclusion that we have little edge after evaluating the event from both and qualitative and quantitative approaches and decide not to play.
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TRADING TECH WITH OPTIONS
We are going to look at 3 Tech Stocks (AAPL, AMZN, FB) that many of you own, short or actively trade and offer ways to add yield, express directional views, and use options to manager position risk.
1) AAPL- The question we get most often from individuals on AAPL, is how to play for a rebound using options to express a bullish view??
Given AAPL’s cash balance of $137 billion, which equals 30% of their $437 billion market cap, their are few stocks that offer a similar risk reward opportunity to Sell Puts on. Obviously this is a strategy that you want to employ when implied volatility is elevated. The Orange line shows the 30 day Implied Vol vs the 30 day Realized Vol in Blue. What is apparent is that vol has settled dramatically since the stock’s earnings gap. Put sales at current levels may not appear to be a slam dunk from purely a vol perspective, but this could set up well on a sell off in the stock and a pop in IV.
On the next decline in AAPL shares, the way to play with options could be a Call Spread Risk Reversal, Sell a Put to Buy a Call Spread
Theoretical Trade: AAPL ($465) Sell the Oct13 400 Put at 19.00, Buy the Oct 500/600 Call Spread for ~19.00 – Entire Trade Structure for Even
- Sell 1 Oct13 400 Put at 19.00
- Buy 1 Oct13 500 Call for 26.00
- Sell 1 Oct 13 600 Call at 7.00
Break-Even on Oct13 Expiration:
- Profits of up to 100 bwtn 500 and 600, max gain of 100 above 600.
- losses below 400
*On a Mark to Market basis prior to expiration, the structure will show losses as the stock moves closer to the short put strike, and gains as it trades closer to the long call strike.
**This structure will require a good bit of margin due to the short put on a higher dollar stock, so sizing will be important.
Trade Structure Rationale: Although calling a bottom in AAPL has been a fools game recently, it’s probably getting to the point where the downside gap risk is much smaller than the potential for a constructive rally of 50 or 100 points over time. This structure takes advantage of those odds by being short a put with a breakeven of 381 to finance the purchase of upside above 500. There is obviously risk below to zero, but the the lower AAPL stock gets the more the odds are in your favor that selling a put naked is worth the risk.
Here’s how the Risk Chart looks for the structure:
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2) AMZN – Picking tops in what appears to be a single name bubble:
PSA, shorting AMZN can be hazardous to your financial health. We continue to believe that Amazon.com remains one of the best not for profit companies in the world, they are a consumers dream, but has the potential to be a shareholders nightmare.
Trying to pick a top in AMZN is basically throwing good money after bad, but if you are in the camp that believes that investors will eventually come around to the company’s challenges, and could ultimately have a similar decline of the magnitude of AAPL since the Sept 2012 highs, one way to express this view with defined risk could be with Wide Long Dated Put Butterflies.
Theoretical Trade: AMZN ($266) Buy July 240/200/160 Put Butterfly for ~5.00
- Buy 1 AMZN July 240 Put for 11.00
- Sell 2 AMZN July 200 Puts at 3.50 each or 7.00 total
- Buy 1 AMZN July 160 Puts for 1.00 each
Break-Even on July Expiration:
- Profits of up to 35 btwn 235 and 165, max gain of 35 at 200.
- Losses of up to 5.00 btwn 235 and 240 & btwn 160 and 165, max loss of 5.00 above 240 and below 160
Trade Structure Rationale:
What this structure does is take advantage of a wide set of profitable areas of the stock with only a small amount of premium committed to the position. The negatives are that it’s a 4 legged structure… but in order to be there with a chance, more simple structures are just too expensive from a premium perspective.
Here’s the Risk Chart:
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3) FB – Another question I get a lot, how do I get my Money back from the FB IPO??
For longs who are looking to do a little stock repair on a well owned stock like FB, which has identifiable resistance overhead ($38 IPO price should keep the stock under wraps considering how large the deal was. Levered overwrites could make sense.
Theoretical Trade: Against Existing Under-Water Long position FB ($27.65), Buy Jun 32/35 1×2 Call Spread for even money.
- Buy 1 FB Jun 32 Call for 1.10
- Sell 2 FB Jun 35 Calls at .55 each or 1.10
Break-Even on Jun Expiration:
- Profits of stock btwn current level and 35, profit of call spread btwn 32 and 35, make up to 3.00. max gain of call spread of 3.00 above 35. If stock is above 35 your long stock is called away at 35, but you have made an extra 3.00 from the call spread so you have essentially sold the stock at 38.00.
- Losses of the stock below 27.65, you have added no additional risk to existing position other than reduced upside.
Trade Structure Rationale:
On its own it carries some upside risk, but this is a great structure to supercharge an existing long. If one was happy getting rid of stock at the 35 level, this structure gives you 3 extra dollars of potential profit to you existing stock position.
Here’s the Risk Chart:
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Implied Moves:
Given the relevance of earnings events on implied volatility of equity options, and the quarterly frequency of such events, we thought it would be useful to quickly touch on how we use equity options to express single stock views around a potentially volatile event
CSCO (~$21)
With CSCO at ~$21, the Feb 21 straddle is offered at ~$1.05, (the Feb 21 call is offered at ~.52 and the Feb 21 Put is offered at ~.53).
If you bought that straddle you would need a $1.05 move up or down by Friday’s close, that’s ~5%.
HOW DO WE DETERMINE THE “EVENT” MOVE?
1) If the earnings fall in a week where there are weeklies options, you can pretty much take the at the money straddle price as a decent estimate of the event move (above).
2) If the event is at least a week out, we need to back out the one day “event” using our implied move calculator (For a rundown on these calculations please visit our discussion here).
Here is a link to our Implied Move Calculator. The Calculator helps us give an approximate estimation of the priced move the options market if the listed strikes don’t fall close to the spot price of the equity or if there are no weekly options and to get sense for how much of the straddle price is time value.
2. Historical moves:
Now we want to look at CSCO’s historical moves following earning. How does the options market view this report vs the past performance? The spreadsheet screen below shows that the average move over the last 4 quarters has been 6.75% and is 8.43% over the last 8 quarters. The implied move of ~5% appears to be a bit cheap to historical:
| eps est | reported | % move | |
| 11/13/12 | .46 | .47 | 4.81% |
| 8/15/12 | .455 | .39 | 9.63% |
| 5/09/12 | .466 | .476 | -10.49% |
| 2/08/12 | .43 | .44 | -2.10% |
| 4 qtr avg | 6.75% | ||
| 11/09/11 | .39 | .40 | 5.68% |
| 8/10/11 | .38 | .39 | 15.95% |
| 5/11/11 | .37 | .38 | -4.78% |
| 2/09/11 | .35 | .36 | -14.16% |
| 8 qtr avg | 8.43% |
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DISCLAIMER: Risk Reversal does not provide recommendations, investment advice or any other advice to you or any other party, and no information or material provided herein is to be relied upon for the purpose of making or communicating investment or other decisions. Do not base any investment decision upon information provided herein. You should consult with your own financial adviser with respect to your own investment portfolio and circumstances.