Monday Advanced Lab Notes

US Steel
Short Strangle
Example
10/26/09

1. US Steel (X) releases its earnings tomorrow after the close.

2. IV should drop drastically after an earnings release.

3. Selling a strangle is a play on that IV drop. This only makes sense if you believe the options are overpriced relative to the risk in the position.


Short Strangle before Earnings

Philosophy
a. Because options are inherently overpriced before an earnings release we look to sell both a call and a put on the same stock at low delta strike prices to collect a credit. This trade is mostly based on Implied Volatility. When IV is high (pre-earnings) options are more expensive, after earnings IV drops and makes options less expensive. This is why we put this trade on. It’s a basic trade on time passing, volatility falling and the stock acting normal in regards to direction.
b. IV will fall on earnings. So when you factor IV changes for this strategy you should assume a drop in IV.
Construction
c. You can find the candidates at the following websites:
i. http://www.optionslam.com/
ii. http://www.earnings.com/
d. Use options 3 expiration months out
e. Sell a call and a put on the same stock at the same time
f. Use strike prices with a delta of .15~.25 ~ you can go slightly outside of this range remember delta is a starting point you also need to consider credit and the distance from the current price to the strike price.
g. Both strikes need to be worth more than .50 per contract
h. Don’t spend more than 2% of your account in buying power effect (margin)
i. Enter the trades on a day that the VIX is at a high and look to enter all of the candidates you have targeted for the next week or so
j. Check the IV for the stock and if its not at least 10 points higher than the VIX then pass on the candidate
k. The goal is to have balance in delta, price and distance between the strikes when you put the trade together. This isn’t always achievable but that is the goal.
l. When you enter a strangle make a note in your journal as to when the earnings release will be so you can come back and look at the stock a little closer that day.
m. Low priced stocks (less than 20) are not necessarily disqualified, but I don’t like them as much in general.
n. Low volume stocks don’t provide as much liquidity in the bid/ask spread ~ so I focus on stocks greater than 1 million shares per day.
Management
o. Once you enter the trade use the risk graph to set a target order. Factor in IV dropping and 3 weeks of time passing. This is your profit target.
p. On the risk side, get out of the trade if any of the following happens:
i. 3-5 weeks of time passes
ii. The delta on either leg goes beyond .40 per contract
iii. There is significant risk in the market, sector or stock you have the position on.
iv. The most important thing to watch will be the individual delta on each leg per contract. If this goes beyond .40 then you need to exit that leg or the entire trade.

Horizontal Spread

Philosophy
a. Enter these trades when you believe IV will build.
b. 3-6 weeks before earnings releases IV starts to build for most companies.
c. Use Earnings.com and go 6 weeks out and find your candidates. Research them using the excel spreadsheet we developed.
d. This trade is based on the idea IV will build, time will pass and the stock will stay in a reasonable range.
e. You do not want to hold through earnings. Always get out before hand.
Construction
f. Buy a longer term option and sell a shorter term option
g. The long option should be 3-9 months in time (default to 3rd or 4th expiration choice)
h. The short option should be 1-2 months in time (only use the front month if the amount of time you’ll be in the trade doesn’t go beyond its expiration.)
i. Don’t spend (this is a debit trade) more than 1-2% of your account in buying power effect.
j. The leg you sell (shorter term) needs to be worth at least .50 cents. And there is no delta criteria for this choice. Choose the strikes that are closest to the current price of the stock.
k. The Strikes you choose should be the same in the long and short options. The only adjustments you can make is in the expiration months for this strategy.
l. Use puts for the horizontal calendar spread.
Management
m. Set a profit target based on 3 weeks of time passing and the assumed IV build you expect in the stock.
n. Here are some other management techniques to use if you don’t hit your profit target:
i. Watch the risk graph and the stock chart. If the price moves outside your breakeven points look to exit the trade.
ii. There isn’t a specific delta rule on this trade like in the other trades. The main reason is that this strategy has structured risk to begin with. Your cost is your risk and since you’re only spending 2% of your account you can be patient.
iii. The main reason you’d exit the trade early is if you don’t believe it will work. If something in the chart ~ i.e. breakout, big volume move etc ~ poses a risk and makes you think the stock can’t come back to the strike prices you’re in then exit this position.
iv. One thing you can check each day is the stock price versus the strike price of your options. As a general rule if the two prices are close to each other you won’t have to do much management that day.

Bull Call Diagonal Spread

Philosophy
o. Enter these trades when you believe IV will build.
p. 3-6 weeks before earnings releases IV starts to build for most companies.
q. Use Earnings.com and go 6 weeks out and find your candidates. Research them using the excel spreadsheet we developed.
r. This trade is based on the idea IV will build, time will pass and the stock will most likely rise. It is a slightly bullish trade.
s. You do not want to hold through earnings. Always get out before hand.
Construction
t. Buy a longer term call option and sell a shorter term call option
u. The long call option should be 3-9 months in time (default to 3rd or 4th expiration choice) at a delta around .50 ~ .90 (generally 70 would be a good delta) (which will put you slightly in the money, generally you can go to the first or second strike lower than the call you sell.)
v. The short option should be 1-2 months in time (only use the front month if the amount of time you’ll be in the trade doesn’t go beyond its expiration.) Sell the call option at a delta of .30 ~ .50 (I prefer closer to 50 delta). This will put you at or slightly out of the money on the sold option.
w. Don’t spend (this is a debit trade) more than 1-2% of your account in buying power effect.
x. The leg you sell (shorter term) needs to be worth at least .50 cents.
Management
y. Set a profit target based on 3 weeks of time passing and the assumed IV build you expect in the stock and the price range you believe the stock will trade at. Remember this is a slightly bullish strategy the reason you chose the call diagonal over the other calendar type spreads is because you believed it will go up. Don’t factor a downside move into your profit target analysis. Just look at the sideways and upward price slices.
z. Here are some other management techniques to use if you don’t hit your profit target:
i. Watch the risk graph and the stock chart. If the price moves outside your breakeven points look to exit the trade.
ii. There isn’t a specific delta rule on this trade like in the other trades. The main reason is that this strategy has structured risk to begin with. Your cost is your risk and since you’re only spending 2% of your account you can be patient.