Kaeppel’s Corner: Gyratin’ All Over, Part II
May 7, 2008
Last week I wrote about the benefits of identifying stocks that are “gyrating” in a given manner. Stocks that are inherently volatile in nature offer certain opportunities to option traders that are not available to stock only traders. To a stock-only trader, a volatile stock primarily offers a lot of risk if the volatility happens to be on the downside. An option trader, on the other hand, can employ various strategies depending on whether the implied volatility of the options of that stock are presently at the high or low end of its own historical range. If implied option volatility is low, then a stock whose price is very volatile is a good candidate for a call ratio backspread or a long straddle (“Gyratin’ All Over," 4/30/08). If implied volatility is high, then a butterfly spread or a condor offers the potential for profit.
Let’s take a look at another possible scenario this week. Let’s go back to the first of 2008. On 3/18/08 the Dow, after forming a double bottom, rallied 420 points. Based on a bullish outlook we will look for a low-risk call ratio backspread. First we run a test in Gyration Stock Finder within Optionetics Platinum software. In this test we are looking for the most “volatile” stocks.
Chart 1 – Gyration Stock Finder looking for “volatile” stocks
While some of the entries on the screen shown in Chart 1 may seem like a bit of hieroglyphics, in a nutshell we are looking for stocks that have fluctuated the most above and/or below a “best fit” line over the past 365 days.
If Chart 2 you see a list of the “most volatile” stocks, identified using the inputs shown in Chart 1.
Chart 2 – Gyration Stock Finder Output
In Chart 3 you see the daily bar chart for Arena Resources, which was the most volatile stock based on the inputs that appeared back on Chart 1. You will note in Chart 3 how often the stock fluctuated above and below the upper and lower lines drawn about the best-fit line. This type of action can offer option traders a number of potential opportunities.
Chart 3 – Arena Resource (ARD)
The next thing we want to do is filter the top 100 stocks identified in Gyration Stock Finder and find those with the lowest implied option volatility. For this we turn to the Option Ranker routine in Platinum. The output is displayed in Chart 4.
Chart 4 – Implied Volatility for volatile stocks ranked by percentile
If you look in the 7th column in Chart 4, you will see that there are four stocks whose latest IV is in the lowest quartile (0-25%) of its historical range – FLO, BWS, HTLD and XCO. Volatile stocks with relatively low implied volatility are often good candidates for ratio backspreads. After examining several possibilities for call ratio backspreads among these four stocks, one that looked interesting was the following:
Sell 2 XCO Sep08 calls @ 4.60
Buy 4 XCO Sep08 calls @ 1.80
Chart 5 – XCO Call Ratio Backspread
Chart 6 displays the risk curves for this trade.
Chart 6 – Risk Curves fir XCO Call Ratio Backspread
As you can see, the options have 185 days left until expiration and there is profit potential to the upside if the stock rallies, and some profit potential to the downside if the stock falls apart. If we resolve to exit this trade if it does not show a gain after 123 days then the maximum risk if only about $400.
By 4/15/08, XCO had in fact rallied quite sharply to 23.33. Our backspread is sitting with an open profit of $560 dollars as you can see in Chart 7.
Chart 7 – XCO Ratio Backspread with an open profit
At this point, the choices are to exit the trade and take the profit, to let it ride and hope we don’t lose the open profit, or to adjust the trade. In this case, to illustrate an example of a trade “adjustment," let’s sell one Sep08 22.5 call at 3.00 and use the proceeds to buy the Sep 22.5 put at 2.15. By itself this trade amounts to a synthetic short stock position (because we are short a call and long a put). However, by adding this position to our current open position we get something completely different. Likewise, we will also resolve to exit the trade no later than 7/21/08 (i.e., 60 days prior to expiration). This leave us with a position with the risk curves displayed in Charts 8 and 9.
Chart 8 – Adjusted XCO Trade Legs
As you can see in Chart 9, we have basically turned this trade into a straddle, whereby we now have unlimited profit potential on both the upside and the downside.
Chart 9 – Risk curves for adjusted XCO trade
Summary
As with the example last week, the idea of this piece is to give you some ideas regarding the potential usefulness of options. While most new traders start out simply buying calls or puts to try to leverage a bullish or bearish opinion, or writing covered calls, you can see there are a lot of ways to play “shades of gray” with options. In this example we found a volatile stock with relatively low implied option volatility. By entering a backspread we had profit potential to both the upside and the downside and about $400 of risk if the stock remained unchanged. By adjusting the trade after it garnered an open profit we were able to “lock in” a profit and can now let this trade ride for a period of time to see if we can accumulate more profits.
The trick in trading option is to know what you are looking for and how to take advantage of specific situations.
To search for previous articles written by Jay Kaeppel, please click here.
Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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