$NKE, $RHT and Vol Spike Hangovers

by CC March 23, 2016 11:53 am • Trade Ideas

Yesterday we detailed trades into two earnings events, Nike (NKE) and RedHat (RHT). The two stocks have nothing to do with eachother other than they were both reporting on the same day. But I wanted to circle back to each stock and look at what happened with those trade ideas and maybe look for larger lessons we can learn about event trading following wild moves in the broader market.

First, let’s look at NKE. The company beat earnings estimates but disappointment investors on future orders and guidance. The stock is down a little more than 4% right now. We previewed the earnings yesterday and looked at the earnings event move that was being implied by the options market:

Right now the March 24th options are implying a $3.85 move in either direction by this Friday’s expiration

We then detailed trades that targeted moves in either direction based on that implied move, one bullish or as a stock alternative with defined risk, and one bearish or as a hedge. Here’s was the bullish:

Buy the NKE (64.75) March 24th/ May 67.50 call calendar for 1.00
  • Sell 1 March 24th (weekly) 67.50 call at .77
  • Buy 1 May 67.50 call for 1.77

This trade was bullish and the risk was the stock going down, which it did. But since it had defined risk and a lot of time to play out on the long strike of the trade (the May 67.50 calls) it’s not a total disaster and is actually much better than having owned the stock into the event. With the stock now at 62 this trade is worth about 50c, for a 50c loss. But the stock is down nearly $3 and there’s still a lot of time between now and May for the stock to rebound. As far as trade management it probably makes sense to see how the stock acts here and whether a bounce from this morning’s lows is in the cards. In that case the May calls may be less of a loss and can possibly even be spread at some point by either rolling the calendar and selling April 67.5 calls or by turning the May calls into a call spread by selling the May 70 or 72.5 strike.

We also detailed a Bearish trade that could either be done outright, or as a hedge vs long shares. This too targeted the implied move, but to the downside. Here was the trade:

NKE  (64.75) Buy the March24th (weekly) 65/60/55 put fly for 1.30
  • Buy 1 March24th 65 put for 1.95
  • Sell 2 March24th 60 puts at .35 (70 cents total)
  • Buy 1 March24th 55 put for .05

This is about a double right now and with the 60 line nearly worthless is basically just long the 65 put expiring Friday. It’s nearly 100 deltas and should be treated as short stock but with defined risk. And that was the intention.

The next thing I want to look at is RHT, it too is down on earnings, about 5% (was only down 3.5% most of the morning). The implied move was nearly 8%! Dan had this to say yesterday about that implied move:

The options market is implying about an 8% one day move which is very rich to the 4 qtr average of about 3.5%, but basically in line with its 10 year average.

it might not be prudent to fade a move higher, but it might make sense to fade the implied move of about 8%.

If I were inclined to make a bearish leaning bet with defined risk, I might consider the April / May 67.50 put calendar, selling one of April 67.50 puts to open at 85 cents and buying to open one of the May 67.50 puts for 1.50, with the spread costing me 65 cents.

With RHT down only 5% that trade is profitable (worth about .95 vs the .65 risked) but not massively because the strike was targeting the implied move and the stock under-performed that implied move to the downside.

And this brings me to a theme to keep in mind in trading event moves following such large reversals in implied vol in the broader market. When we saw the VIX spike as high as 30+ in January and February that was on macro concerns that affected the entire stock market and was felt in individual stocks as investors paid up for disaster protection in their portfolios. That’s atypical to normal earnings season volatility spikes where vol is low and steadily rises into the earnings events. So what happens often times in these situations is that volatility is over priced for the individual event moves in a somewhat complicated set of circumstances. But the important thing to remember is that the cycle of investors reaching for protection into an event and market makers raising implied volatility to sell that protection is a bit upended as a lot of the investors already reached for that protection in the months beforehand and the event itself can actually be seeing lower implied volatility than recent months.

That creates a sort of implied volatility hangover where market participants are loaded with much more gamma than usual, and that has a realized vol dampening effect on the stocks themselves as there is more stock to be bought on declines and more stock to be sold on pops from the gamma effect on deltas.

This is a bit wonky and isn’t a rule of thumb that can be used for all events, but it’s something to be aware of after big spikes followed by big declines in the VIX. That vol hangover may be over pricing individual stock movement and and can have a snowball effect on declining option prices until it clears from the market through option expirations. You’ll hear a lot of people say “Buy Volatility” once it’s come in after a big spike, but you want to be as patient as possible so you can wait out that hangover. What are the signs to look for? A break of the trend of daily moves of less than 1% in the market that we’ve seen recently. As well as a sustained move to the downside that lasts more than 1 day and isn’t immediately bought the next day.

Side note: the opposite is true of events in the middle of a broader market volatility spike as options may not be properly pricing individual stock movement with all the short gamma in the market and those moves can accelerate through lines with heavy short interest as stocks need to be chased by market makers to stay delta neutral.