With the CBOE Volatility Index (CBOE:VIX) trading below 20, we are seeing some interesting opportunities to buy options for “discounted” prices. Simply put, stocks are moving more then the implied volatility suggests they should.
Last week I outlined some blowup trades, and I’d like to update you on the results to date. The trade on Caterpillar (NYSE:CAT) made the maximum gain ($1.60), a 19% rate of return (ROR). The trade on Netflix (NASDAQ:NFLX) also hit the maximum profit of $3.00, a 17% ROR. Earnings reports from Amazon (NASDAQ:AMZN) and Baidu (NASDAQ:BIDU) should result in a maximum gain of about 60 cents on AMZN and $1.20 on BIDU. These are huge returns for a one-week time frame, with an average ROR of 18%.
This week, I want to do the same short butterfly position, this time on Green Mountain Coffee Roasters (NASDAQ:GMCR), which is trading at about $53 right now.
As a reminder, a short butterfly – buying two at-the-money options (i.e., the body) and selling one in-the-money option and one out-of-the-money option — is a fairly conservative strategy … and a profitable one, as you can see from the gains listed above.
Here is what I am doing this time with GMCR:
- Selling 10 $50 calls for Feb 3rd expiration
- Buying 20 $55 calls for Feb 3rd expiration
- Selling 10 $60 calls for Feb 3rd expiration
This can be done for about a $1.10 credit. (In other words, you get paid to do this trade.)
I need a move of $3.90 to hit breakeven on this trade at expiration. If GMCR moves further than $3.90 in either direction, I will make money on this trade.
What I am anticipating happening is GMCR moving $7 or more; this should be more than enough for me to quickly make my maximum profit of $1.10.
Making Money with Volatility, Pre-Earnings
There are a select few stocks that have an extremely sharp rise in volatility running up into their earnings dates. This sharp rise in volatility can actually affect the options prices enough to offset any time decay in the position, as well as make you money even if the stock doesn’t make a move.
In other words, you can structure trades like straddles and strangles without having to worry about time decay while waiting for the stock to move. Or, in many cases, you can close the position for a profit without a move in the stock whatsoever.
You may remember from last week that the long straddle is often used as a strategy to trade earnings when you believe a stock will move … but you’re not sure which direction. By buying a call and a put at the same strike price, with the same expiration date, you hope to earn more on the winning side of the trade than you lose on the other side.
And the long strangle is a similar strategy, but one in which the strike prices are different. You’re still buying a call and a put that have the same expiration dates. But the call you buy would have a higher strike price than the put you buy. This strangle may appeal more than the straddle because it should be just a little cheaper to enter.
GMCR is a stock I absolutely love to do this trade on. In fact I opened this trade last week and ended up closing it out three days later because the stock made enough of a move to make a 60-cent profit. You could structure any kind of blowup position to take advantage of this sharp rise in volatility. For example:
Buying the $52.50 straddle on GMCR:
- Buy 10 calls at $52.50
- Buy 10 puts at $52.50
Both expire the same week earnings are released (Feb 3rd expiration).
Any option structure that benefits from a rise in volatility is a viable candidate for this trade.
Making Money with Volatility, Post-Earnings
Once a company reports earnings, the implied volatility drops back to near normal levels in the options, instantly deflating the prices.
However, on the more-volatile stocks like NFLX, the implied volatility in the options does not return to normal levels until a few days after the earnings report comes out. This is due to the uncertainty of where the stock will finally settle after the big news.
We can take advantage of this by structuring a trade that benefits from a drop in volatility. Here is the trade I am doing on NFLX, which is trading at $120 as of this writing:
Forward 2-to-1 ratio on NFLX (for every call I buy, I sell two at a higher strike price):
- Buying 10 $135 calls for Feb 3rd expiration
- Selling 20 $140 calls for Feb 3rd expiration
This can be done at the time I am writing this for a 35-cent credit.
If the stock never approaches the nearer-to-the-money strike, then the trade will expire worthless and I will keep the 35 cents. If it creeps higher and approaches the near strike, I will close it out for a much bigger profit (around $1.50-$2).
The risk in this trade is a very sharp rally above $145. The trade makes money as long as NFLX doesn’t rally by more than $20 by expiration.