Tim Bovee, Private Trader: GM: Volatility play

Update 11/3/2014: GM never fulfilled my expectations for a significant post-earnings bounce, and I've exited my very-short-term volatility play for a profit, with four trading days left in the life-span of the options.

The stock declined by 0.43% over the 12 days I held the position, or -13.11% annualized.

The options produced a 75% yield on risk, or +42.86% annualized. As is always the hope in shorting options over the very short term, time decay out-paced the price rise, allowing a profit despite a slight adverse movement in the stock.

Update 10/22/2014: I've opened a bull position in GM, structured as discussed in the "Trade" section below. The stats are 3.9:1 leverage and $30.29 for the breakeven point at expiration. The short leg of the position has a 61.2% chance of expiring out of the money, for maximum profit.

GM hit a post-Great Recession high of $41.85 on Dec. 26 and has since traced a zig-zag downward, with the final leg (which I've labeled C), ending on Oct. 15 at $28.82.

Click on chart to enlarge.

GM 1 year daily bars (left), today 2-minute bars (right)

The price has since moved upward, and for a very-short-term volatility trade, it's the very recent micro-movements that I care about.

The rise since Oct. 15 is an uptrend that has hit a high so far of $31.51 in trading today. It then slipped off into a counter-trend triangle that showed a strong breakout. I decided at that point that the momentum was sufficient to take the trade.

Of course, the beauty of a short options spread is that it will make money as long as the price stays above the breakeven point. A sideways trend works just fine, and I can even take a small amount of downtrend while remaining profitable.

I've had a change of heart on GM's earnings announcement. I had pegged implied volatility as lower than I like. I'm in the midst of a study on volatility and earnings, and what I've learned so far suggests that my standards may be set too high. So here's an analysis of GM as a volatility play.

General Motor Corp. (GM) publishes earnings on Thursday, Oct. 23, prior to the opening bell. (GM in Wikipedia)

Volatility

GM's implied volatility stands at 32%, in the 54th percentile of the one-year range and down from the 61st percentile the prior trading day. Volatility has been declining since Oct. 15, producing the hook pattern that shows a trend change.

Implied volatility, which is forward loo,ing, stands 9% below historical volatility, which looks backward.

The question of volatility in the context of an earnings play revolves around the question, how low is too low. For my strategy to work, I need a drop in implied volatility after earnings are announced. I trade short option spreads, sold for a credit, and part of my profit comes from the volatility drop.

The most profitable volatility play I've had all year was on AAPL, which had volatility in the 61st percentile just prior to the earnings announcement. Like GM, it also showed a hook.

Up until now I've classified volatility by quintiles, with anything from the 40th percentile downward counting as low, 40th to 60th as neutral, and 60th upward as high. The AAPL experience, which volatility just barely in the high quintiles, is causing me to doubt my method.

So the 54th percentile for GM sends a mixed message: It's low, which theoretically limits the drop, but it is in a decided downtrend, which implies more decline to come.

Chart

GM hit its low on Oct. 15 and has since risen by 9.4%. Intraday, Wednesday began with a steep rise, which dropped some after a peak, and has since resumed its uptrend, although the price remains below the high of the day.

The stair-step upward is a clear uptrend, even at that small resolution.

Earnings

Analysts are forecasting a 2% increase in earnings over the year-ago quarter. GM has produced four downside earnings surprises over the past three years, most recently in the most recent quarter. All other quarters in the period have produced upside surprises.

Trade

Based on the trends, large and small, I see GM as being in an uptrend going into earnings. The Street expectations are positive. So I'll consider a bullish trade.

I would structure the trade as a bull put spread, short the $30.50 puts and long the $29.50 puts, sold for a credit and expiring Nov. 7. The position at the current price would have 3.8:1 leverage and would be profitable at expiration down to $30.27, a 3% cushion at the present pre.

Decision for My Account

I intend to take the trade if upward or sideways intra-day momentum continues. I'll post an update once I get the fill.

-- Tim Bovee, Portland, Oregon, Oct. 22, 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.