Buying a Straddle on Oracle
Last week I told you about a pre-earnings announcement on Nike. With the stock trading around $65, we bought calendar spreads at the 62.5, 65, and 67.5 strikes for an average of $.33 each, guessing that if the stock ended up near any one of these strikes, that spread would be worth over a dollar and cover all three spreads. The stock shot up more than 11% after the announcement, and was closest to the 70 strike. The calendar spread at that strike was worth $1.20, so we were right on that score. But we didn’t have any spreads at that strike, and we lost money for the day. In future calls in companies like Nike which have a history of big moves after announcements, we will add extra out-of-the-money calls and/or puts to provide insurance against huge moves of this size.
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Buying a Straddle on Oracle
On Friday, with Oracle (ORCL) trading at $32, I bought an April straddle (both a put and a call) at the 32 strike. The straddle cost me $1.40. The stock will have to move in either direction at least $1.40 for the intrinsic value of my straddle to be at break-even (although it will not have to move that much for the straddle to be able to be sold for a gain as there will always be some extra premium value in the options I own).
Let’s look at how much Oracle has fluctuated each month for the past two years:
Oracle Monthly Price Changes Last Two Years
- Oracle Chart March 25 2013
Only two times in the last two years has Oracle failed to move at least $1.40 in one direction or another in a single month. That means that an at-the-money straddle purchased for $1.40 at the beginning of the month could have been sold for a profit at some point during that month 22 out of 24 times.
Many times, there would have been an opportunity to more than double your money, and while the maximum loss is theoreticlly $1.40 per spread, last week, with a week of remaining life, the 32 at-the-money straddle could have been sold for $.72 which means that if you closed out the spread with a week remaining, the worst you could do would be to recover half your initial investment. (If the stock were at any price higher or lower than $32, the straddle would be worth more than $.72 with a week remaining).
The big challenge with these kinds of spreads is deciding when to sell. One way is to place a limit order when the spread reaches a certain profit level, say 50%, and take that gain whenever it comes. In our example, that would mean placing an order to sell the straddle at $2.10. The above table shows that in more than half the months (13 out of 24), you could have sold the straddle for at least a 50% gain. I like those odds.
The stock does not have to fluctuate the full $2.10 in order for the straddle to be sold at that price. As long as there is time remaining in the options you hold, they will be worth more than the intrinsic value. The $2.10 price might be hit if the stock only fluctuates $1.80 or so if it does it early in month.
Another way of selling the spread is to place limit orders at slightly more than what you paid for the straddle if either the put or call reaches that price. You might place a limit order to sell the puts at $1.43 and another order to sell the calls if they reach $1.43. In either case, you get all your money back (plus the commission) and you have either puts or calls remaining that might be worth a great deal if the stock reverses itself and moves in the opposite direction. The stock might have to move only about $1.20 in either direction for one of these trades to execute.
We typically place orders to sell half of our original spreads if either the puts or calls can be sold for the original cost of the straddle. That way we get half our money back (almost assuming that we will not lose money for the month) and if the stock continues in the direction it has started, a huge gain might be made on those remaining options, and if the stock reverses, you have twice as many of the other options that might grow in value.
Most of our investments at Terry’s Tips involves selling premium and waiting over time for decay to set in, all the time hoping that the stock does not fluctuate too much (as that hurts calendar spreads). It is fun to have at least one investment play that does best if the market does fluctuate, and the more the better. Buying a straddle on Oracle gives us that opportunity, and the history of the stock’s fluctuations shows that it is a pretty good bet.
How to Play the Nike (NKE) Earnings Announcement
How to Play the Nike (NKE) Earnings Announcement
Calendar spreads in NKE seemed so attractive that we placed 20 Apr-Mar4 spreads last week at three different strikes for an average cost of only $.33 – if the stock ends up anywhere between $52.50 and $57 (currently about $54.50), the long side of one of those spreads with four weeks of remaining life should be worth at least $1.00, more than covering the cost of all three.
I checked prices this morning and the three spreads could be purchased for only a little more – an average of $.35.
NKE announces earnings on Thursday, March 21st after the close. Expectations seem to be high – whisper numbers are $.76 vs. analysts’ projection of $.68 and the stock has gained 20% over the past three months – high expectations typically cause disappointment with some part of the announcement and a lower stock price afterwards.
We will want to place trades that will allow for the stock to drop in price by a greater percentage than it could go up and still make a gain on the spreads. Here are the trades that we placed:
These spreads cost a little less than $3500 to place. The diagonal put spread is the most expensive, but will about double in value if the stock moves down to $52.5 or lower.
Here is the risk profile graph which shows the likely gains or losses at the close of trading on Friday:
Implied volatility (IV) of the Mar4-13 options (43) is nearly double that of the Apr-13 options (23) which gives us a large IV advantage with these calendar spreads. In the above graph, we assumed that IV of the April options would fall to 20 after the announcement.
The graph shows that if the stock falls less than 8% on Friday or goes up by less than 5%, we should make a gain with our positions. The highest gain (about $2000 on an investment of about $3500) would come if the stock were to fall about $2 after the announcement.
We like our chances here.
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Using Puts vs. Calls for Calendar Spreads
A lot of our discussion lately has focused on pre-earnings-announcement strategies (we call them PEA Plays). This has been brought about by lower option prices (VIX) than we have seen since 2007, a full six years ago. With option prices this low it has been difficult to depend on collecting premium as our primary source of income with our basic option strategies.
But the earnings season has now quieted down and will not start up again for several weeks, so we will return to discussing more conventional option issues.
Using Puts vs. Calls for Calendar Spreads
It is important to understand that the risk profile of a calendar spread is identical regardless of whether puts or calls are used. The strike price (rather than the choice of puts or calls) determines whether a spread is bearish or bullish. A calendar spread at a strike price below the stock price is a bearish because the maximum gain is made if the stock falls exactly to the strike price, and a calendar spread at a strike price above the stock price is bullish.
When people are generally optimistic about the market, call calendar spreads tend to cost more than put calendar spreads. For most of 2012 and into 2013, in spite of a consistently rising market, option buyers have been particularly pessimistic. They have traded many more puts than calls, and put calendar prices have been more expensive.
Right now, at-the-money put calendar spreads cost more than at-the-money call calendar spreads. As long as the underlying pessimism continues, they extra cost of the put spreads might be worth the money because when the about-to-expire short options are bought back and rolled over to the next short-term time period, a larger premium can be collected on that sale. This assumes, of course, that the current pessimism will continue into the future.
If you have a portfolio of exclusively calendar spreads (you don’t anticipate moving to diagonal spreads), it is best to use puts at strikes below the stock price and calls for spreads at strikes which are higher than the stock price. If you do the reverse, you will own a bunch of well in-the-money short options, and rolling them over to the next week or month is expensive (in-the-money bid-asked spreads are greater than out-of-the-money bid asked spreads so you can collect more cash when rolling over out-of-the-money short options).
The choice of using puts or calls for a calendar spread is most relevant when considering at-the-money spreads. When buying at-the-money calendar spreads, the least expensive choice (puts or calls) should usually be made. An exception to this rule comes when one of the quarterly SPY dividends is about to come due. On the day the dividend is payable (always on expiration Friday), the stock is expected to fall by the amount of the dividend (usually about $.60). Since the market anticipates this drop in the stock (and knowing the specific day that the stock will fall), put prices are generally bid higher in the weeks before that dividend date.
The bottom line is that put calendar spreads are preferable to call calendar spreads for at-the-money strikes (or even at strikes slightly higher than the stock price) coming into a SPY dividend date. Even though the put spreads cost more, the Weekly options that can be sold for enough extra to cover the higher cost. You do not want to own SPY call calendar spreads which might become in the money on the third Friday of March, June, September, or December because you will have to buy them back on Thursday to avoid paying the dividend, and you may not want to make that purchase to keep your entire portfolio balanced.
OptionsXpress Drops Auto-Trade
OptionsXpress no longer offers their Auto-Trade service which enabled clients to follow their favorite newsletter’s recommendations without placing each trade themselves.
This is just another reason why thinkorswim is a much better alternative for anyone who wants to trade options, and you can now get over $300 worth of free services from us at the same time.
Use this link to sign up – open thinkorswim account – and once you have funded your account with at least $3500, email Seth@TerrysTips.com and let him know that you have done it, and this is what he will do – sign you for our Premium Service package ($119.95 value plus an extra 4 months of our Premium Service, valued at another $190.80). You get $300.65 worth of services without paying us one penny.
As another benefit, Terry’s Tips subscribers are eligible for lower commission rates that I can’t put in writing until you become a paid subscriber. These rates will apply to all of your option trades at thinkorswim, not just those where you might be following our trade alerts.
Even More Pre-Earnings-Announcement Plays
Case Study of a PEA Play (Salesforce.com): Last week, in two different Terry’s Tips portfolios we gained 24.8% in less than 24 hours with the following trades.
In the week preceding the earnings announcement, several articles were published on Seeking Alpha that panned Salesforce.com (CRM).
A sample, with a quote from each:
“When viewed from the fundamentals, the current valuation of Salesforce is absurd.”
“… at this dilutive speed, the Salesforce.com stock is little more than a Ponzi scheme.”
“What has occurred at Salesforce in recent years are efforts to maximize insider shareholder wealth with no regard to and to the exclusion of outside shareholders.”
Other articles mentioned the huge amount of insider selling at the company – in the last six months, over $150 million was sold by company insiders, about 8% of their holdings. (Most of the sales occurred in late December, 2012, however, and I concluded that it was largely due to efforts to avoid the capital gains tax increase that was expected to come about in 2013.)
In opposition to all this negativity about the company, we saw indications that the stock might not fall after earnings (as so many other companies have done). There had not been a big run-up in the stock price leading up to the earnings announcement, whisper numbers were not higher than analysts’ expectations, and most important of all, the company had almost a perfect record of having higher stock prices after earnings, even when they missed expectations. For those reasons, when we placed the positions in place, we allowed for more room on the upside than on the downside.
Here are the trades we placed:
February 28, 2013 Trade Alert – Earnings Eagle Portfolio – LIMIT ORDERS
These trades will get us set up for today’s earnings announcement after the close for Salesforce.com. Our break-even range extends to about 7% on the downside and 10% on the upside and we only have one day of price changes to worry about:
BTO 4 CRM Apr-13 155 puts (CRM130420P155)
STO 4 CRM Mar1-13 155 puts (CRM130301P155) for a debit limit of $2.71 (buying a calendar)
BTO 4 CRM Apr-13 160 puts (CRM130420P160)
STO 4 CRM Mar1-13 160 puts (CRM130301P160) for a debit limit of $2.99 (buying a calendar)
BTO 3 CRM Apr-13 165 puts (CRM130420P165)
STO 3 CRM Mar1-13 165 puts (CRM130301P165) for a debit limit of $3.12 (buying a calendar)
BTO 3 CRM Apr-13 175 calls (CRM130420C175)
STO 3 CRM Mar1-13 175 calls (CRM130301C175) for a debit limit of $3.10 (buying a calendar)
BTO 4 CRM Apr-13 180 calls (CRM130420C180)
STO 4 CRM Mar1-13 180 calls (CRM130301C180) for a debit limit of $2.93 (buying a calendar)
BTO 4 CRM Apr-13 185 calls (CRM130420C185)
STO 4 CRM Mar1-13 185 calls (CRM130301C185) for a debit limit of $2.48 (buying a calendar)
These trades were placed with CRM trading about $169. These spreads cost $6365 to place including commissions ($55). Note that the largest numbers of contracts were placed at the upper and lower extreme strike prices, and no spreads at all were at the at-the-money 170 strike. These choices resulted in a relatively flat risk profile graph curve with a little more coverage on the upside than the downside.
There was a huge implied volatility (IV) advantage to our calendar spreads. IV for the Mar1-13 weekly options was 100 compared to 36 for the Apr-13 options. The big question was how much the April options would fall in value once earnings were announced. We estimated that IV would fall by 5, (to 31) after the announcement. With this assumption, the risk profile graph looked like this:
The graph shows that a $1500 – $2000 gain might be expected if the stock made only a minimal change in value after the earnings announcement. We set out to create positions that would result in a gain if the stock rose less than 10% or fell less than 7% after the announcement, and the graph showed that we had that coverage.
What happened, however, was that IV of the April options fell all the way to 27, reducing the amount that we were able to gain on the trades. The stock opened up about $7 higher, at about $176. Here are the trade alerts that we issued and the prices we got for the spreads:
March 1, 2013 Trade Alert – Earnings Eagle Portfolio – LIMIT ORDERS
With the stock higher we will take these spreads off first:
BTC 4 CRM Mar1-13 155 puts (CRM130301P155) for $.03 (no commission)
STC 4 CRM Apr-13 155 puts (CRM130420P155) for $1.70
BTC 4 CRM Mar1-13 160 puts (CRM130301P160) for $.05 (no commission)
STC 4 CRM Apr-13 160 puts (CRM130420P160) for $2.50
March 1, 2013 Trade Alert #2 – Earnings Eagle Portfolio – LIMIT ORDERS
Now we will take this one off:
BTC 3 CRM Mar1-13 165 puts (CRM130301P165) for $.05 (no commission)
STC 3 CRM Apr-13 165 puts (CRM130420P165) for a limit of $2.20
March 1, 2013 Trade Alert #3 – Earnings Eagle Portfolio – LIMIT ORDERS
BTC 3 CRM Mar1-13 175 calls (CRM130301C175)
STC 3 CRM Apr-13 175 calls (CRM130420C175) for a credit limit of $4.80 (selling a calendar)
BTC 4 CRM Mar1-13 180 calls (CRM130301C180)
STC 4 CRM Apr-13 180 calls (CRM130420C180) for a credit limit of $5.75 (selling a calendar)
BTC 4 CRM Mar1-13 185 calls (CRM130301C185)
STC 4 CRM Apr-13 185 calls (CRM130420C185) for a credit limit of $4.90 (selling a calendar)
During the day, the stock moved higher, trading as high as $183.24 ($14 higher than it was when we placed our trades).
When we bought the calendar spreads on Thursday, February 28th, our cost was $6365. This entire amount was really not at risk because the long April options would always have a greater value than the Mar1-13 weekly options that we had sold, and we were planning on exiting all the trades on Friday, March 1 (so there would be no further decay in our long options).
We lost money on three of the six spreads we bought but the gain on the other three spreads was much greater than our losses on the losers. We collected $7985 from selling the spreads and paid $41.25 in commissions for a net receipt of $7943.75 and a gain of $1578.75 after commissions, or 24.8%.
We continue to learn. First, we underestimated how much IV falls after the announcement. Second, our idea that stock fundamentals are not as important as expectations in PEA Plays was reinforced (and historical results after earnings is also important). Third, taking off the spreads furthest away from the stock price early is the best way to go (all these spreads ended the day well below what we sold them for).