Tim Bovee, Private Trader: AAPL and KO: Volatility plays

Update 10/21/2014: AAPL rose sharply post-earnings and I've exited as it began to give a bit of those gains back. To call the results "excellent" is an understatement.

APPL gained 3.2% during the single day lifespan of the position, or 1,169% annualized.

The options spread produced a +127.6% yield on debit, or +46,569% annualized. (I feel a bit silly to be annualizing to such a huge number, but that is indeed what it works out.)

This experience has illustrated for me the importance of getting the direction right. Yes, the implied volatility is also quite important but no less important than a price forecast.

I got it right this time by paying close attention to the chart on the day of the trade, and indeed during the few minutes before placing the trade. There are other ways of doing it, I'm sure, if only I have the wit to see them.

So one task for the weekend -- perhaps earlier -- will be to do a revision of my rules for very short term volatility trades in order to strengthen the price-forecast leg of the process.

Update 10/20/2014: I've switched direction on AAPL, structuring it as a bull put vertical spread, because of the strong intra-day upward momentum that carried the price up 1.6% from the pre-market to a half hour before noon New York time. The price has since pulled back a bit, but it still appears to have sufficient power to suggest a bullish mood.

I structured the new trade as short the $96 puts and long the $95 puts, sold for credit and expiring Nov. 7. It is a bit closer in to the at-the-money mark than the former bearish version was, a change I made to get the risk/reward ratio down to where I was happy with it, generally around 3:1.

The short leg has a 65.9% chance of expiring out of the money; my requirements is 60% or better. The leverage is 3.9:1.

In my discussion of both stocks below I alluded to the difficulty in picking direction for such short-term trades. Because they are of such short duration, the judgement, I'm finding, of what which direction works can change very quickly.

Click on chart to enlarge.

AAPL 10/20/2014 approx. 2:10 a.m. New York time, 5 days 10 minute bars

The Cupertino, California computer company Apple Inc. (AAPL) announces earnings after the closing bell today (Oct. 20), and the world's largest soft drink company, The Coca-Cola Co. (KO) of Atlanta, Georgia, announces the next morning before the opening bell. (AAPL in Wikipedia. KO in Wikipedia.)

AAPL

Volatility

Implied volatility peaked at 38% on Oct. 15 and then took a sharp downward hook, declining to 32%. The hook is precisely the pattern I look for in a volatility play, and indeed in my rules I've made it a necessary feature for a trade.

Prior to the hook, AAPL's volatility had been working its way upward from the most recent low, 23%, recorded on Sept. 18.

The Oct. 15 peak was the highest point of AAPL's implied volatility over the last year. The hook brought it down to the 72nd percentile of the one-year range. That's sufficiently high to support a short options spread sold for a credit and expiring within a month.

Implied volatility stands 33% above historical volatility.

Options are pricing in confidence that 68.2% of trades will fall between $93.40 and $101.94 over the next week, for a potential gain or loss of 4.4%, and between $95.73 and $99.61 over the next day.

Chart

AAPL, like most stocks, has come off its peak of September but remains quite high relative to where it was a year ago. The price joined everyone else in the heavy sell-off of the past week, and also in the slight recovery on Friday that carried forward in early trading on Monday.

Volatility declined in in response each of the last four earnings announcements and the price rose in two and went sideways in two. For the purposes of a short bearish options spread, I consider a sideways move to be almost as beneficial as a decline, so I consider this to be an excellent record for trading

The price post-earnings score is 2 and the volatility score is -4, giving a net -2 score. (See the "References" section below for a description of my scoring method.)

Earnings

The Street expects earnings to come in above the year-ago quarter and the quarter immediately prior.

AAPL has produced two downside earnings surprises in the past three years, both in 2012. All other quarters in that period have been upside surprises.

Trade

See the update at the top for a description of how I actually structured the trade.

I won't place the trade until shortly before the market closes. ~~If I were placing it at the present price ($97.67), I would structure it as a bear call spread using the weeklys, short the $101 calls and long the $102 calls, sold for a credit and expiring Oct. 31.~~ I looked at the next expiration out, Nov. 7, but it only added a few cents to the premium I collect.

KO

Volatility

Coke is not an Apple. KO's implied volatility has the same peak and downward hook pattern, but at a much lower level, as befits a company whose signature product has been around for 128 years.

Volatility peaked later than with many stocks, on Oct. 15 at 24%, and then declined to 22%. It reached the peak by working upward from a low of 13% on Aug. 26.

The 24% level is the highest of the past year. The hook has brought volatility down to the 84th percentile of its one-year range, sufficiently high to support a short options spread.

Implied volatility stands 37% above historical volatility

Chart

KO moved in common with the rest of the market, tracing a steep decline in the past week with a slight recovery on Friday continued in early trading on Monday.

Over the last four quarters, the price has risen three times in immediate response to earnings, and fallen once. Implied volatility has been the mirror image, falling three times and then rising once.

In this behavior KO has met the stereotype perfectly: Declining volatility means rising prices, and vice versa.

The post-earnings price score 2 and volatility, -2, for a combined score of zero. This is not promising for a bearish short options spread -- do I play the price with a bull put spread or the volatility with a bear call spread? It's impossible to say.

One thing is certain: The price movements have been consistently directional in response to earnings, so a sideways strategy, such as an iron condor, seems inadvisable.

Earnings

The Street expects earnings to come in identical to the year-ago quarter and well below the immediately prior quarter. Since last quarter was summer, the big season for soft-drink sales, the drop-off is a normal feature of the yearly cycle.

KO has produced three downside earnings surprises in the past three years, all during a rough patch that impacted the last two quarters of 2013 and the first of 2014. Eight of the remaining nine quarters surprised to the upside.

Trade

I have no way of picking a direction KO so I can't construct a trade. See the "Decision for My Account" section below for further discussion.

Decisions for My Account

I intend to open a position in AAPL, most likely placing my trade in the half hour before the closing bell.

KO is problematic. I have no way of picking a direction using the scoring methods described in the "Chart" section. Projected earnings are no help. And even the market as a whole is ambiguous. That the market is in a downtrend there is no doubt, but this is a very short term trade, and KO (like AAPL) has risen for three days, the definition of a very short term trend.

The volatility strategy for playing earnings is a new one for me, developed less than two weeks ago. The question of direction is the knottiest of all in a strategy like this, where the expiration deadline is so close.

For now I'm satisfied to rely on my the scoring method I developed over the weekend, modified by the Street expectations and the price and volatility trends, while keeping an eye open for ways to improve.

I won't be playing Tuesday's earnings announcement for KO under my very short term volatility rules, although I shall keep a very close eye on how the stock responds to 1) learn and 2) consider whether it might be worthwhile to jump on board immediately after the open, since the post-earnings price movements have tended to continue significantly, both in duration and span.

-- Tim Bovee, Portland, Oregon, Oct. 20, 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.