Tim Bovee, Private Trader: LOW, SPLS: Volatility plays

The Mooresville, North Carolina-based home improvement retail chain Lowe's Cos. (LOW) and and the office products chain Staples Inc. (SPLS), headquartered in Framingham, Massachusetts, announce earnings Wednesday morning, Nov. 19, prior to the opening bell. [LOW, SPLS in Wikipedia]

LOW

Volatility

LOW's implied volatility stands at 29%, compared to 14% for the S&P 500. It lies within the 73rd percentile of the rise that ended Oct. 15 at 33%.

The one standard deviation range implied by options pricing, encompassing 68.2% of trades, produces a potential gain or loss of 8.2%, and the two standard deviation range, encompassing 95% of trades, a gain or loss of 16.5%.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	$63.75	$68.60	$59.16
Lower	$54.03	$49.18	$49.85

Implied volatility 1 and 2 standard deviations; chart support and resistance
The high end of both the one standard deviation range and the two standard deviation range are above the upper resistance on the chart, while the lower end of the one standard deviation ranges is above the lower resistance level on the chart and the two-standard deviation lower end, near equal to its on-chart counterpart, giving expectations for LOW an upward bias.

The price hit a high of $59.16 on Tuesday and has pulled downward today. I consider the chart to be bullish still, but the trend today runs counter to that assessment, producing a degree of ambiguity.

Click on chart to enlarge.

LOW 1 year daily bars

The Trade

LOW lacks Weeklys in its options inventory, meaning that the monthly contracts expiring Dec. 20 are the shortest lifespan of any practical trade.

The contracts expiring Nov. 22 have only four more days left to trade, which is a shorter period than I'm comfortable with. This close to expiration, time decay has taken its toll to such An extent that it's hard to get a decent premium on a short sale of options.

The December options, however, have 34 trading days left until they expire, more than double my ideal lifespan of two weeks for this sort of trade.

The upside of options is that they have higher open interest than their Weekly counterparts do. The downside of LOW's options grid is that it has only a few strike prices expiring in December: 11 strikes altogether, spaced $2.50 apart near the money.

My goal will be to set up a trade that is bullish -- a nod to options expectations -- but also provides downside protection -- a nod to today's chart truth. My vehicle will be a bull put spread offset from the at-the-money level as much as I can while still getting a semi-decent risk/reward ratio. I'll sell the spread for a credit.

The lowest practical protection is to show the $55 put, only slightly above the lower side of the one standard deviation options-implied range. However, this produces a 6.2:1 risk/reward ratio, which means I have to assume an extra dose of risk to gain the potential for a fairly small profit.

A better option is to short the $57.50 put, producing a 2.3:1 risk/reward ratio at the price of leaving much of even the one standard deviation range in loss territory. Also, $57.50 is the first strike below the money. It's almost the same as no protection at all.

In any case, it's the only partial alternative available on this grid:

Probability of expiring out-of-the-money Short the $55 put and long the $52.5 put, sold for a credit and expiring Dec. 20.

DEC	Strike	%
Lower	$55	75.23

SPLS

Volatility

SPLS's implied volatility stands at 43%, compared to 14% for the S&P 500. It lies within the 93rd percentile of the rise that ended Nov. 12 at 44%.

The one standard deviation range implied by options pricing, encompassing 68.2% of trades, produces a potential gain or loss of 12.3%, and the two standard deviation range, encompassing 95% of trades, a gain or loss of 24.7%.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	$14.57	$16.17	$13.50
Lower	$11.37	$9.77	$11.39

Implied volatility 1 and 2 standard deviations; chart support and resistance
The chart price peaked on Nov. 15 and reversed sharply, dropping like a rock for two days. The rise that culminated in that dramatic reversal began Oct. 8 from $11.39. This is a chart with considerable downside potential, especially since the reversal came within a counter-trend correction.

Click on chart to enlarge.

SPLS 1 year daily bars

The Trade

SPLS, like LOW discussed above, lacks Weeklys in its options inventory, so any trade must fall upon the contracts expiring in December. SPLS does have the advantage of more strike prices with greater granularity: 17 strikes spaced a dollar apart.

The bearish chart suggests a short bear call spread offset from the at-the-money level to provide some upside protection.

At this point I discover the horrifying truth of the SPLS options grid: Open interest is highly concentrated in two strike prices near the money, leaving the others with insufficient liquidity.

The best I can do will be short the $13 calls, providing little upside protection in comparison with the options implied ranges, although it is close to the chart truth. The risk of expiring out-of-the-money, where the profit lies, is on the low side, at 59.83%

The risk/reward ratio is a reasonable 2.3:1

Probability of expiring out-of-the-money Short the $13 call and long the $14 call, sold for a credit and expiring Dec. 20

DEC	Strike	%
Upper	13	59.83

Decision for My Account

I'm reluctant to tie up money for the next month on a volatility play. By then LOW and SPLS will be far beyond their response to the earnings announcements. Given the volatility of volatility, a month is an aeon in this sort of trade.

I won't be trading either of these symbols today.

-- Tim Bovee, Portland, Oregon, Nov. 18, 2014

References

My volatility trading rules can be read here. For a discussion of the rationale behind the rules, see my essay, "Rules for very short term trades".

From time to time I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

My method of scoring price and volatility responses to earnings, used in the "Chart" section, is the simplest imaginable. Looking at the four most recent earnings announcements, I give one point for a rising price or rising volatility in the week after the announcement, subtract a point to a falling price or volatility, and give a zero if the response is sideways movement. I then add the four quarters together to produce separate scores for price and volatility, and then add the two to produce a combined score.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.