Tim Bovee, Private Trader: MSFT, F, PBR, PG: Volatility plays

Update 10/27/2014: I've exited my positions in both MSFT and PG, the first, bullish, for a profit and the second, second, for a loss, after the prices reversed and moved against the direction of the trades.

I'll take MSFT first.

The price began falling in the pre-market of the second trading day following the earnings announcement, and continued to fall for 45 minutes after the opening bell. At that point it stabilized and indeed took back a portion of the loss. But on the third day post-earnings it opened sharply lower, and I got out.

The shares had a net gain of 1% over the four-day life of the position, or 92.5% annualized.

The options produced a 45.8% yield on debit, or 4,187% annualized.

Next, to PG, whose earnings came in 5.8% above market expectations. The market responded with short rise prior to the opening bell, leaving me on the wrong side of an uptrend. I held for a bit hoping for the not-uncommon contrarian response, but it didn't happen to any meaningful expense, so I got out.

The shares had a net gain of 3.1% over 4 days, or 285.1% annualized. The options produced a loss on debit of -136.4%, or 12,443.2% annualized.

PG has been in a sideways trend for nearly a year. An Elliott wave framing of the chart shows that the sidewinder is a 4th wave correction within a larger-degree 3rd wave of an uptrend. Given the look of the chart, a continuation of the sideways trend was not an unreasonable bet, and in fact was the higher probability in my book book.

The present break above prior resistance could be just a slight overshoot rather than a serious breakout, but the nature of very-short-term trading is that it doesn't allow the time to see how things work out. So the breakout changed the equation, making continuation of the long-running rise the more likely outcome, and I exited. with 11 days left until expiration,

Click on chart to enlarge.

PG 2 years daily bars

Update 10/23/2014: I've opened a bull position in MSFT as a volatility play, structuring it as a bull put spread, short the $44.50 puts and long the $43.50 puts, sold for a credit and expiring Nov. 7.

Leverage is 4:1, and the break-even is $44.26, or 1.9% below the entry price. The short leg has a 63% chance of expiring out of the money.

I've also opened a bear position in PG as a volatility play, structuring it as bear call spread, short the $84 call and long the $85 call, sold for a credit and expiring Nov. 4.

Leverage is 7.5:1 with the breakeven point at $85.33, 2.6% above the entry price. The short leg has a 64% chance of expiring out of the money for maximum profit.

Microsoft Corp. (MSFT) publishes earnings after the closing bell today, and three companies public before the opening bell on Friday: Ford Motor Co. (F), Petroleo Brasileiro Petrobras SA (PBR), and The Procter & Gamble Co. (PG). (In Wikipedia: MSFT, F, PBR, PG)

MSFT

Volatility

MSFT's implied volatility stands in the 62nd percentile of its one-year range, having peaked on Oct. 17 and then hooked downward.

Options re pricing in confidence that 62.8% of trades will fall between $42.79 and $45.97 over the next week, for a potential gain or loss of 3.6%, and between $43.86 and $45.10 over the next day.

Chart

MSFT's price has been rising since Oct. 16, and in those five trading days it has moved to 6.8% above its low at the start of that period.

For the near term, MSFT is in an uptrend. However, it must count as a counter-trend correction, since it is embedded in a downtrend that began in October.

MSFT declined intra-day on Wednesday. The direction of any trade will depend largely on the microtrends visible on the 5-minute chart for the day.

Volatility and prices have both fallen post-earnings in three of the past four quarters, and both rose in one quarter, the furthest back in time.

Earnings

Analysts expect earnings to come in 21% below the quarter a year earlier. MSFT has surprised to the downside three times in the past three years, including in the most recent quarter. All other quarters in the period of surprised to the upside.

Trade

I would structure any trade as a short vertical spread, sold for a credit and expiring Nov. 7. The details must await my judgement on the direction of the play, which will rely on today's intraday price action.

The at-the-money bid/ask spread on calls for that expiration is 7.1%.

F

Volatility

F's implied volatility stands in the 50th percentile of its one-year range, having fallen sharply from its Oct. 16 peak. It has the lowest implied-volatility percentile of the four prospects, and for that reason I'm rejecting it out of hand and shall forego further analysis.

PBR

Volatility

PBR's implied volatility, by contrast, is the highest of the prospects, standing in the 84th percentile of its one-year range. Volatility peaked for the year on Oct. 10 before beginning its downward hook.

Options are pricing in confidence that 68.2% of trades will fall between $10.52 and $14.44 over the next week, for a potential gain or loss of 15.7%, and between $11.59 and $13.37 over the next day. It is a very volatility stock.

Chart

PBR is in an aggressive downtrend, both nearer term and farther term. The peak of $17.64 on Oct. 13 kicked off a steep decline that so far has travelled 29.7%.

Earnings

Analysts forecasts PBR's earnings as coming in 48% above the year-ago quarter. PBR has surprised to the downside in half the quarters of the past three years, including the two most recent. The other quarters surprised to the upside. PBR has reported a loss once in that period, back in 2012.

Trade

I would structure my position as a bear call options spread, short the $14 call and long the $15 call, sold for a credit and expiring Nov. 7.

PBR's at-the-money bid/ask spread on puts with that expiration has a a bid/ask spread of 19.5%, a very high level that is more than I'm willing to assume. I consider it to disqualify PBR for a trade.

PG

Volatility

PG's implied volatility stands in the 73rd percentile of its one year range, having declined from the year's high of 23% on Oct. 17. Volatility has hooked upward in a two-day rise off of Tuesday's 18% low.

Options are pricing in confidence that 68.2% of trades will fall between $80.42 and $84.98 over the next week, for a potential gain or loss is 2.8%, and between $87.66 and $83.74 over the next day.

Chart

PG has been on a rapid decline from its high of on Oct. 17, having fallen 2.8% from there. Most of the move has come from today's 2.4% decline.

The decline is in line with a longer-term decline stair-stepping down from September's peak.

Earnings

Analysts expect earnings to be up slightly from the year-ago quarter.

PG has surprised to the downside only one in the past three year, in that same year-ago quarter.

Trade

If I take the trade, I'm looking to structure it as a short bear call spread, short the $85 calls and long the $86 calls, sold for a credit and expiring Nov. 7.

PG's at-the-money bid/ask spread for calls of that expiration is 7.4%.

Decision for My Account

The devil, as always, is in the details, specifically the price movement intra-day on the day of the trade. I've tossed out F for its its lower volatility and PBR for its wide bid/ask spread.

MSFT has the better volatility pattern, having hooked to the downside and continued to point in that that direction. PG's upward move from the hook may be a deal killer. We shall see.

In any case, I'll update this analysis with details of any further action on take on those symbols.

-- Tim Bovee, Portland, Oregon, Oct. 23, 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.