The recent massive sell off in AAPL stock has
presented some interesting opportunities for low risk trades. For long time
readers of this column, you may recognize that my portfolio usually contains
an AAPL position.
Why? I
cannot overemphasize the importance of trading liquid instruments, and in the
current world, very few underlying issues have options with the degree of
liquidity routinely available in a wide spectrum of strike prices and
expiration dates.
What is
the big deal about liquidity? When markets trade in an orderly fashion it is
usually possible to negotiate a reasonable price for all but the most
illiquid underlying. However, when blood is running in the street, market
makers will routinely widen bid / ask spreads and attempt to extract well
more than a pound of flesh. It is only in the most liquid series that any
hope of a reasonable exit in these times can be found.
Ok, sermon
is over; I like AAPL! For those who have not looked at the option chain for
AAPL since last Thursday, I want to call attention to another new aspect of
the tremendous flexibility that exists in this name. Entirely new sets of
weekly options are now trading, not just those for the next upcoming Friday
expiration.
This means
as I type on Tuesday morning, I can trade liquid options for calendar year
2012 that expire in 3, 10, 17, 24, or 31 days. That is a lot of choices and
will allow us to exploit a never before level of granularity in constructing
our trades.
The trade
I would like to discuss is a high probability of success trade that is based
on the expansion of implied volatility in AAPL as a result of the brutal sell
off that has brought the stock from its recent highs a bit over $700 to its
current price of $565 despite yesterday’s neck snapping $30 / share
rally.
As regular
readers know, the first characteristic I evaluate in seeking a high
probability trade is that of the current status of implied volatility. AAPL
is one of a handful of stocks that have listed values for implied volatility.
As an
aside, the history and current status of implied volatility is discernible
for all stocks having listed options, but may require access to a broker
database or one of several fee based sites.
The
current status of implied volatility for AAPL, symbol VXAPL, is shown below:
As is
obvious, the value has “come in” recently but still remains in
the upper half of its recent range, particularly when excluding the
characteristic spike in volatility preceding the recent release of third
quarter earnings in October. Since currently elevated levels of implied
volatility indicate that options are rich on an historic basis, it seems
logical to consider a trade that benefits from
selling these rich assets.
The purest
way to sell option premium in a non directional
based trade is to sell a naked strangle. A naked strangle is a position
established by selling both a naked put and a naked call. The trade is
typically constructed in far out-of-the-money strikes, typically with a delta
valued at an absolute value of 5 to 10, and having duration of 25 to 35 days.
I have
illustrated below the P&L curve for a 10 lot naked strangle for December
monthly options. The put and call are sold at the $475 Put and the $630 Call
strikes. The trade has an 87% probability of profitability and yields 9% for
a 32 day holding period.
A word of
explanation of the manner in which the probabilities are derived is in order.
One of the helpful practical characteristics of the options
“Greeks” is the fact that the delta of an option is closely
correlated to its probability of being in-the-money at expiration.
In the
case of the options we are selling, the puts have a delta of -6 and the calls
have a delta of 10. This means the puts have a probability of 94% of being
out-of–the-money at expiration and the calls have a probability of 90%.
The
probability of both contracts being out of the money is therefore 0.9*0.94=
.84 or 84%. The credit we initially received serves to broaden the
profitability zone a bit, resulting in the stated 87% probability of profit.
This is a
very capital intensive trade with unlimited risk. In the illustrated
size of a 10 lot trade, the buying power reduction required in a regulation T
account is around $56,000. On this basis, the trade yields 9% at expiration.
For those
with risk based margin, more commonly known as Portfolio Margin, the margin
is a bit less than half that amount. This dramatic reduction in margin
requirements results in a yield in excess of 18%.
These
trade constructions illustrate the pure return and probabilities of success
for a premium selling approach and illustrate the logical thought process of
pursuing such a strategy. An important caveat is that these unlimited
risk trades such as illustrated must be taken in small size relative to the
total portfolio to reduce risk and allow for adjustments when price does not
behave.
While
these structures are not common and require a certain degree of capital and
professional understanding, the probabilities and potential returns are such
that small positions can result in large profitability outcomes on a monthly
basis.
Right now
we are offering a special trial offer for traders interested in trying out
OptionsTradingSignals.com! The recent track record has been almost too good
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Happy
Trading & Happy Thanksgiving!
JW
Jones
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