Tim Bovee, Private Trader: TIF: Volatility Play

Tiffany & Co. (TIF), a jewelry chain based on Fifth Avenue in New York City, publishes earnings after the opening bell on Tuesday, Nov. 25. [TIF in Wikipedia]

Implied volatility is extremely high and positioned for a fall on an up trending chart that appears, over the very near term, to be pulling back in a counter-trend correction.

The problem, as is often the case, lies on the options calendar: TIF has no Weeklys in its derivatives inventory, only the monthly contracts. The next expiration is in December, 25 days away.

Volatility

TIF's implied volatility, at 35%, compared to 13% for the S&P 500, stands in the 98th percentile of a rise that culminated on Nov. 19. It has been moving sideways since Nov. 19 and today moved down while remaining above the lower boundary of the sideways-trending channel.

Options are pricing in confidence of a 4.9% potential maximum gain or loss within the one standard deviation range, encompassing 68.2% of trades over the next week, and a 9.7% gain or loss over the two standard deviation range, encompassing 95% of trades.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	108.74	113.77	105.24
Lower	98.67	93.64	101.24

Implied volatility 1 and 2 standard deviations; chart support and resistance
TIF is in an uptrend and has been since mid-October and hit a peak on Friday, Nov. 21. It has since pulled back in a classic retracement that to me suggests more downside potential.

TIF 30 days hourly bars (left), 5 days 4-minute bars (right)

The Trade

The first rule for very short-term trading of the sort I'm contemplating today is this: "Play the today's trend, not last week's." The decline that began on Friday is clearly a downtrend on the chart, despite it's coming within a fairly impressive uptrend.

The implied volatility is quite high, in the 98th percentile, easily meeting my prerequisite for a short options spread.

The downside is that TIF has no Weeklys among its options contracts, and the next monthly expiration is Dec. 19. I generally prefer two weeks out at the maximum, although I might be able to work with this.

My bias is bearish, based on the current trend, so I'll structure the position as a bear call spread. With a fairly narrow choice of strike prices, I can get the chance of expiring out of the money for maximum profit into the 70s, but not the 80s.

Higher probability Probability of expiring out-of-the-money Bear call spread, short the $110 calls and long the $115 calls, expiring Dec. 19 and sold for a credit

DEC	Strike	%
Upper	110	75.57

This risk/reward ratio at that is is 4.8:1, broader than I like. That high a relative risk cuts into my potential profit under my trade-sizing rules. On the other hand, it does provide excellent protection of the entire range of confidence encompassing 68.2% of trades over the next week and the entire range between support and resistance on the chart, although it leaves the upper reaches of the 95% range of confidence uncovered.

Lower probability Probability of expiring out-of-the-money Bear call spread, short the $105 calls and long the $110 calls, expiring Dec. 19 and sold for a credit

DEC	Strike	%
Upper	105	56.92

I can lower the risk/reward ratio to 1.9:1, but only at the cost of leaving the upper portion of the 68.2% range of confidence unprotected. The second potential trade also reduces the probability of expiring out of the money to below 60%.

Decision for My Account

There are some options grids that just don't work very well. TIF's is one of them. I'm passing on this trade because I can't get both an acceptable risk/reward ratio and protection over the entire 68.2% confidence range.

-- Tim Bovee, Portland, Oregon, Nov. 24, 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.