Finding Option Opportunities - Part 2
08/07/2013 8:00 am EST
In the second part of his article on how to find option candidates, Russ Allen of Online Trading Academy, outlines the remaining steps involved.
Last week’s article, which you can read here, was part 1 of this two-part discussion on finding option opportunities. I noted that there are many ways of doing this, and described a method that involves looking for stocks or ETFs whose options are extremely expensive, and then selling those options.
The process I described has nine steps, listed below. I described steps 1-5 last week, and today we’ll finish up with the rest. I’ve summarized steps 1-5 in a few words below.
- Locate stocks with currently unusually high Implied Volatility – IV – relative to their own IV history. High IV means expensive options.
We found American Tower Corp. (AMT), which was at its highest IV for the past year.
- Check the stock’s price chart and decide whether it is a bullish, bearish, or neutral picture.
AMT was in the middle of a range between 70 and 80—a neutral chart.
- Select an option strategy to match the price outlook – iron condor if neutral, otherwise short options or credit vertical spreads.
We were neutral, and chose the iron condor.
- Select strike price(s) that the stock is unlikely to reach by the front month expiration date, and plan the trade.
We chose the 70 put and 80 call for our short options; and the 65 put and 85 call for protection.
We used August options, which then had 30 days to go.
- Calculate underlying prices for maximum profit, maximum loss, and break-even. Use option diagramming software to facilitate this.
These were the numbers (all prices as of the August 17 option expiration date):
- Maximum loss of $372 with AMT either above $85 or below $65.
- Maximum profit of $128 with AMT anywhere between $70 and $80.
- Downside break-even price $68.72.
- Upside break-even price $81.28.
Further details are in last week’s article. Below is the price chart of AMT, with these prices marked.
Now for the remaining steps:
- Identify the stop/unwind price(s), where the trade will be abandoned for a loss if necessary.
Although the maximum loss was $372, we would not plan to wait for that $372 max loss to occur. Instead, we would plan to completely unwind the position if either our demand zone was violated (AMT below $70), or our supply zone was violated (AMT above $80). These were our stop-out prices. The fact that we considered these strong zones was the reason for considering the trade. Exiting before expiration due to price going outside our profit zone would result either in a small loss or a small profit. Two things would determine the exact profit or loss we’d have when/if the trade was stopped out.
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The first factor was how long that price move took. The longer it took, the better. We would be earning money each day as all the options lost value. That’s because the options we were short (the 70 put and 80 call) were closer to AMT’s $73.87 price than the options we were long (the 65 put and the 85 call). Being closer to the money, the short options had more time value in them to begin with than the long options had. So time would diminish the value of the short options faster than that of the long ones—time decay was our friend. If time decay had taken away enough value from the short options when the stop-out occurred, we could still have a profit.
The second factor was how implied volatility changed. Decreasing IV would help us, as it would cause a drop in value of all the options. Decreasing IV is similar in effect to the passing of time—it reduces the value of all options, with a greater effect on options that are closer to the money. Conversely, rising IV would hurt us, since that would increase the value of all the options. We wanted IV to stay the same or drop. Since AMT was already at a 52-week high in IV, we believed that its IV was more likely to drop. That was what drew our attention to AMT in the first place.
- Evaluate the likelihood of stock being in the profit zone at the target date.
We had earlier decided that $70 and $80 were good demand and supply levels, which we expected to hold in the near term. We then needed to check whether there were other factors, which might make it less likely that those levels would hold. First we checked for earnings announcements. We found that AMT was scheduled to report earnings on July 31, two weeks out. Looking at the price activity on the last few earnings dates, we found that the stock had moved, but always $5 or less. With that information alone, we would modify our plan slightly, and plan to hold the position through the earnings announcement only if AMT were still pretty close to the middle of the $70-$80 range. If not, we would unwind the position on July 30, just before the earnings announcement. We could still make some money if AMT were within the range at that time, although not the full profit.
As a last check, we looked for news stories that might help explain the extra-high IV. In general, we don’t emphasize “trading the news,” but there are a couple of categories of news stories that we do have to pay special attention to. One of those is takeovers. If a company is taken over by another, its stock will soar right up to the takeover price and stop there. We didn’t find anything that would indicate that. Another category is fraud or other scandal. In this case, we found that the analyst firm Muddy Waters was promoting a story about possible accounting irregularities, or maybe downright fraud, on the part of AMT. If this story panned out, the stock might tank in a spectacular way, gapping through our maximum loss level without warning. I vividly remember a situation just like that, as an uneducated investor in 1999. I had too much of my portfolio in another stock called Prime Retail Outlets. Prime was trading about $11 just before a fraud story broke after hours. The stock immediately cratered to $4.
NEXT PAGE: Patience is a Virtue|pagebreak|
In AMT’s case, the stock had already reacted with a $6 drop earlier in the day that the Muddy Waters story broke (July 17); but it had recovered almost all of that by the end of the day. It did not look as though the story was gaining traction, so we decided to go ahead.
- If all looks good, place the trade.
We went ahead and sold the iron condor, receiving $128 in credit. This involved buying to open the August 65 put for $63 and the August 85 call for $15; and selling to open the August 70 put for $145 and the August 80 call for $58. This was done as a single order for all four legs, for a net credit to our account of $128.
- Enter the order(s) to unwind the trade if the underlying hits the stop/unwind price(s) .
We put in an order to close out the whole trade if AMT moved outside our profit area of 70 to 80. The first order was to buy to close the $70 put at market, contingent on the price of AMT trading either above $80 or below $70. Then, using the order-sends-order facility in TradeStation, we specified that that buy-to-close order would trigger additional orders to buy to close the $80 call, sell to close the $65 put, and sell to close the $85 call. The details of how this is done differs from one trading platform to another, but as long the software supports both contingent orders and OSO, it can be done.
Once all the orders were in place, it was a matter of waiting for time to pass.
By the afternoon of July 30, the night before the earnings release, AMT was at $72.44. Although still in our 70-80 profit zone, it was in the bottom quarter of it. Our plan was to hold the position through the earnings release only if AMT was still near the middle of the 70-80 range. Since it was not in the middle, but much closer to the bottom of the range, we followed our plan and closed out the trade.
By that time, 13 days had passed since we put on the trade, and AMT’s IV had dropped from 48% to 29%. We first canceled our existing stop-out orders. We were then able to buy to close the 70 put for $90, and the 80 call for $10, taking $100 out of our pocket. We then sold to close the 65 put for $19, and the 85 call for $5, putting $24 back in it. The net cost to exit trade was $100-24 = $76. Subtracting this from the $128 we had received on entering the trade, we ended up with a profit of $128-76 = $52. This worked out to 13.9% of our $372 money at risk in 13 days, an annual rate of return of over 390%.
In the end, we followed our plan, and it paid off. We found a stock whose options were overpriced and sold those options; and later bought them back when both time and volatility had diminished their value. Meanwhile, we had only limited risk because of the options we purchased for protection.
By Russ Allen, Instructor, Online Trading Academy