Wednesday, October 18, 2006

Vol Risk: Strangles Before Earnings

The title really says it all and most of the traders who have lost enough money in the game know how vol risk works. However, it is nice to be reminded of it every so often.

Case in point being last night's IBM earnings.

As the sentiment was so upbeat and the stock quite overextended the obvious thing to do was to buy the 85/90 strangle. Historically, post-announcement the stock would either pop a lot higher or drop like a stone. Either of these things tended to happen quite reliably when the stock ran up or down into earnings and peaked on volume.

Since I like scalping gamma we put on a synthetic by buying Nov 90 calls and selling the stock. With the stock trading at 87.50 towards the end of the day, buying 30 calls per every 1000 shares sold short resulted in a perfect delta neutral position. So, any appreciable move in the underlying would result in long or short deltas automatically banking us a profit. Simple, naive and actually workable.

Of course I looked at the vol of the calls prior to buying and found it at 21 - above the mean of 17. So, the vol risk was there and it was quite probable the vol would implode post-announcement.

I just didn't think it would implode to 16.

So, when IBM opened at 90.60 the strangle should have resulted in a nice profit - had the vol stayed near the 19-20 level. Instead it actually lost money - not a lot - but enough to be reminded that vol risk is very real and is to be respected. Knowing what I always knew about this (trading 101) this morning made me feel like a little boy.

The stock did end up running to 92 and thankfully the strangle made money by the time it had crossed the 91.10 barrier. So, shedding the "little boy" image and turning into a temporary daytrader I scalped the slowly emerging delta as the stock got taken higher.

A nice profit overall, but a sobering lesson nonetheless: making money on this strangle shouldn't have involved my stock trading skills.

Bottom line: if you play long gamma/vega prior to an announcement, don't assume your vega exposure won't do you in. So, hedge it. And if you don't know how then don't put on the strangle.


Wednesday, October 11, 2006

Oil Bear

It's uncommon for me to get bearish after long and quite vicious declines. Goes against my adopted contrarian's grain. But, as a contrarian I look for nuances and while I saw these nuances in earlier price action in Oil (circa Sep 20) - that prompted a series of excellent trades on the long side - they have since disspiated and made the current decline unattractive.

Not that I'd go short right here but I am now bearish enough to sell a rally with an outlook for a few more dollars on the downside. That's what the commodity itself looks like to me today.

Now, let's throw in some equities into the mix and we see our favorites (VLO, TSO, NE, etc.) break down, rally and consolidate below their recent support levels. In addition, OIH managed to frustrate an army of both long and short players within the last six weeks and still stayed in a tough consolidation below its support.

In general, as dictated by our directional model, when support breaks and the price stops falling, it is a cause for alarm. Pretty contrarian, eh? The basic reason lies in the fact that if support break were fake, an immediate rally would ensue that should carry the price back above the broken level. When this does not happen, two things can follow: either the price continues to fall (naive but often true) or it stops falling and moves sideways.

When the latter occurs, the odds for a continuing move lower are quite high. Naturally, random events will alter any particular scenario but the overall odds over a large enough sample certainly favor negative price action.

Following this digression into trivialities of chart reading I no longer have a reason to be an Oil bull. And I have several to turn myself into a bear.

So, I change my mind. I change my mind because as a trader this is what I do.


P.S. Does this mean I should be a bull on non-oil equities? Good question!

Tuesday, October 10, 2006

Selling Pain

Another one of my infrequent posts comes in what I believe to be an opportune moment currently borne by the waves of the U.S. equity markets.

OK, that wasn't too poetic. In fact, the recent events are anything but - for us, contrarians, that is. However, when pain sets in and then gets worse, my battle-worn senses tell me that opportunity is very near. Just like in all the other times when an urgent need to spit blood prevailed over any other feelings.

So, I hear all this talk about the Dow setting a new high and the "educated" crowd crowing that inflation-adjusted, it is actually down 15%. Hence, the exhuberance is driven by ostensibly "fake" numbers.

Eh, maybe.

However, that's not what makes me an almost net put buyer. I see a few other things from my technically driven astral plane:

1. Put vol on many stocks, especially the leaders like GS has collapsed. In fact it collapsed (as in, below its mean) on many issues and that in itself gives a buyer an edge.

2. I see lots of parabolic rises often ending on higher than normal volume. If you don't know what that means, read one of Jesse Livermore's studies. You'll learn something trivial but also irrefutably true: trends tend to end after a prolonged move accentuated by a rise in volume.

3. I see no long opportunities from a contrarian standpoint. Meaning: if you like chasing things or buying breakouts, there are a plethora of setups. However, consider that one of my core put selling strategies is to sell puts in exactly these situations ... when put vol is high. See number 1.

4. I see nothing going down in a way that would make a value play attractive. I look at the markets all day long and I see waves of things running up. It's like an ocean with a huge tide consisting of waves that try outrun each other. The tide edges higher and higher. We all know what happens to tides.

Ultimately, I am not calling a big top. As a trader I am only good at calling trades and here I am calling a tradable correction.

BTW, having this view I think the best way to exercise it is via buying puts on individual issues (watch the vol) or selling stock if puts aren't available. Selling call verticals right here isn't a bad idea either. For example a GS October call spread (185/190 strikes) will yield 10%. Not bad for two week's worth of work.

Trade 'em up and watch your risk. The best way to make money is to make sure you keep it.


Saturday, September 23, 2006

Natural Gas - The Amaranth Signal

We've all heard about the trouble and Amaranth and I won't regurgitate the news. My point is not to rant about the fund but to deliver a short observation:

It's the same thing as Oil. Looking at the technicals I see absolutely no reason to sell here and all the (technical) reasons to buy. Like I said in my previous post, we'll see these prices again.

It's a strong buy signal for a trade and Amaranth's "blowup" just made it a whole lot stronger.


Wednesday, September 20, 2006

Oil: Capitulation?

This is a big question and by the sound of it it seems to require a big answer. I am sure that with enough research of the sector's and the commodity's fundamentals, analysis of market order flows, comparisons to the past, etc., several strong, "big answer" views can be formed.

As a trader and by no means a well-equipped analyst, I will offer a small one:

December futures are trading at 61.70 and we are betting a large sum of money that we will be seeing this price again.

"Great!", you say. "You call that a view?"

Well, from my perspective, which has an extremely shallow, admittedly singular basis called "making money", it absolutely is. If I told you that there was at least a 95% chance that 61.70 was a price that we will be seeing in the future, would you consider that information as a tradable view?

To be fair, this really boils down to your trading methodology. One of the methods sometimes applied at Cadence is bottom fiishing (feel free to read my recent article posted at that describes the strategy). In a nutshell, when an asset falls hard and fast after a prolonged decline (I am oversimplifying) chances of a near bottom being formed are very high. Obviously, a glace at the Oil chart that includes today's close will show a nearly perfect example of such scenario.

Now, knowing that the bottom is near, how is my trading view relevant?

It's less than immediately obvious. The easy part is of course that I am dead on right and Oil will go higher from here. If you believe me then you'll run out and buy a pile of Globex futures right now and enjoy your profits as soon as you decide that you've made enough. Now, the not so easy part is that I may be wrong, at which point the issue of risk management comes into play.

Well, here's the clue: I said that I have a high degree of confidence that 61.70 is a price we'll be seeing again. What I didn't say was that most likely, we'll be seeing it on the way up from below. Your profitability will be determined by how much lower we go before we revert to (and likely above) the 61.70 level.

This means that as long as your cost is not much higher than this price, you have a very high chance of being "safe". So, while you may not necessarily make money in the end, the truth is that you're very unlikely to lose much, if any. And, on average, you'll make ok profits.

Word of caution: there is that 5% chance that I am completely, obnoxiously wrong and we won't be seeing 61.70 any time soon. What to do?

The answer is simple if you reaize that this 5% chance quantifies an outlier. And, as all outliers go, the best you can do is cap it with a stop (just like you would with a long leg of a short options spread). Just keep in mind that your stop should respect the increased volatility levels.

Overall, I do happen to think that Oil is capitulating in the short term. I am also fairly confident that once it bottoms somewhere near here it has an upside of $6-8. But this particular statement is just for fun, because we won't be there waiting for the $6 profit to materialize.

That's just not how the game is played.


Thursday, August 17, 2006

Contrarian's View

So bullish out there... And it was just a few days ago when the entire market was screaming "Inflation! Rising rates! Declining house starts! War! Terrorism! Deficit! National debt!"

Then suddenly the tone changed to "Well, we're not in the clear yet but this looks really, really good. The Fed is done. Earnings are great. Screw Middle East. Oil prices are lower."

Yes you've all heard all of this before. Why talk about this banal stuff?

Simple: for a contrarian trader this "stuff" is essential for spotting reversal points. The above are simply sentiment reads and, while admittedly very broad, are very indicative of imminent reversals. I don't want to beat a dead (actually, not so dead at all!) horse, but look at the Housing sector as an example. Mid-July was the perfect buying opportunity amidst trumpteted horrors of collapsing real estate and falling earnings. As crazy as it may sound but buying into that precipitous decline was the only way to trade the sector and those of us who have, have been greatly rewarded.

Going forward, a few things strike me from a contrarian standpoint:
  1. The market is toppy overall but not toppy enough to get short. However, once a flurry of bulish retoric emerges, buying cheap index puts would be the perfect play. This is the only time I would actually warrant buying index options.
  2. The Housing sector isn't done and the latest dip was an excellent re-buying opportunity. There is still a massive overhang of negativity which will produce more buyable dips. By the way, according to Adam, public has been buying calls in the sector in volume. By public I mean non-sell side such as hedge funds and individuals. Weird, huh?
  3. Oil is being quickly forgotten and is nearing at least a temporary bottom. Look to get in below $70 (Sep Crude).

Wednesday, August 09, 2006

Directionally Challenged

We've been glued to the Housing sector. I admit, it's a bit of a marriage at this point - maybe not positionally (we're small long calls at these levels), but definitely trading-wise. I have a lot of reasons to like the sector and any "fell swoop" selloff is attractive. All the dips this far have been excellent buys with vol keeping its levels and even rising (I love owning calls and making money both ways)

Today's selloff is definitely attractive but I have to say that I got spooked by the trading volume. Our favorites, RYL and LEN sold off on nearly double the normal volume. The actual selling in and of itself was fine - the levels that were reached are very buyable, but when I look at the sector overall and bring the volume into the equation, I get excited about selling OTM call spreads.

So, here I am, bullish on the sector (especially at this level) and thinking to sell calls. Directionally challenged? Absolutely.

So, what do we do?

Two posts ago I made a recommendation that right now looks promising - buy gamma. One thing I am willing to bet a lot of money on is that this sector is going to keep moving and as long as you're willing to sit there and flip stock, you'll make money.

But, a little problem: RYL vol ticked at 52 today. That's the same level as it was when RYL made a big bottom in mid-July. Why a problem? Because two days ago the stock made a top. So, either this vol signals the end of the two day selling spike (which means it's about to implode), or it's going higher, which means we'll see lower levels in the stock.

So, taking that into account, gamma doesn't look so good.

Two things left on the table:
  1. A sudden move lower in the morning on volume will make for a quick play to the upside. I recommend just buying stock if you willing to play at all.
  2. If this selloff gets rejected by a sustained rally, further dips will become buyable again.
Sanity rests with option 2.


P.S. I promise to get off this Housing topic soon as there are plenty of other things to talk about. But there is so little insight into this sector beyond the boring, regurgitated fundamental views and earnings report that seem to be carbon copies of each other, that I hope that my technical insight brings at least some new value.