On October 10th we looked at Procter & Gamble (PG), very near 52 week highs, considering the recent rise in the U.S. dollar and Treasury yields into an increasingly likely rate increase at the FOMC’s Dec 14th meeting and positioned for a pull back. Here was the trade idea and some rationale:
There are two events in the next few months that will determine what’s next in PG. The first is earnings 10/25 before the open, then of course the Fed meeting in December (and to a much lesser extent the one in November). Therefore, any directional bet for a pullback needs to catch the Dec Fed meeting. The stock has also been in a grind for quite some time and there’s nothing stopping it from continuing that lack of volatility, especially if it goes sideways for now. So any directional bet with long premium must be as protective as possible with decay:
*PG (89.25) Buy the Dec 90/82.5/75 put butterfly for 1.95
- Buy 1 Dec 90 put for 3.20
- Sell 2 Dec 82.5 puts at .75 (1.50 total)
- Buy 1 Dec 75 put for .25
As you can see, we chose Dec because it captured two potentially stock moving events. That first event is tomorrow morning as the company is set to report its fiscal 1st quarter earnings before the bell. The options market is implying about a 3% move in either direction, or about $1.75. The reason that’s important is that the stock has declined significantly (about $5) since we detailed the trade idea above. That means the Dec fly is already profitable (worth about 3.50 vs the 1.95 initial cost) but it can be much more profitable if the the stock is in this same spot on December expiration. Therefore the earnings event tomorrow morning is significant as far as trade management. So let’s break down our options here.
The first thing to look at is the extrinsic/intrinsic break-evens of the current trade. As I said, with the stock 84.40 the put fly is worth 3.50 mark to market. But intrinsically (if expiration was today) the structure would be worth 5.60. That missing 2.10 is the short premium yet to be received as there is still significant time until December expiration. Therefore the intrinsic break-even level of our current mark to market profits can be used as a nice stop level on the upside. With a current mark to market value of 3.50, the level of 86.60 can be used as a place to take the trade off for a profit on a move higher. There’d be very little lost as far as profits at that level and on Dec expiration the mark to market would be exactly the same at that level above as it is with a month and a half left and the stock at this lower level.
On the downside, the level to target is the mid point on the fly as that’s the max value potential where this trade could be worth up to 7.50 on Dec expiration.
One big factor with the earnings and this put fly is that implied volatility is higher into the event and that’s actually costing some potential near term gains on the trade. Here’s 30 day implied vol in red:
As you can see, vol has moved higher into the event. In the next few days after the event, vol is likely to be in the low teens, representing a significant decline percentage wise from the current high teens. That means that more gains will quickly be realized in the put fly as some of that short vol comes in. Of course, that’s still dependent on where the stock is after earnings, so deltas are still the number one factor (about -30 deltas here).
So as far as trade management, it’s basically a matter of weighing event risk of the stock being significantly higher versus the greater realized gains that will come after earnings with implied vol lower. If the stock doesn’t move or is lower towards the 82.5 strike, this trade will be worth more tomorrow than it is today. If the stock is slightly higher, within the implied move it will probably still be worth about the same as it is today. IF the stock moves higher significantly higher than the implied move there is risk of it being worth less than it is today. (the final scenario is that the stock is significantly lower than than the 82.5 strike, but that is the least likely from an implied move standpoint.)