Tim Bovee, Private Trader: AMAT, JWN: Volatility plays

Update 11/22/2014: Both option positions expired out-of-the-money for maximum (100%) yield on debit.

AMAT stock gained 1.1% over the eight-day life of the position, or 48.43% annualized and the options' yield was 4,562,5% annualized.

JWN stock gained 2.6% over eight days, or 116.4% annualized, and the options yield was 4,572.5% annualized.

Update 11/13/2014: I have opened positions on AMAT and JWN as described in the analysis below.

Two symbols are on my agenda Thursday as potential volatility plays.

Applied Materials Inc. (AMAT) of Santa Clara, California, which makes the equipment that makes the chips that make up the electronics that populate the seas of our lives, and
the Seattle, Washington-based high-end clothing retail chain Nordstrom Inc. (JWN).

Both publish earnings after the closing bell on Thursday. [AMAT and JWN in Wikipedia]

The three symbols were screened from 29 companies publishing earnings after the closing bell on Thursday or before the opening bell on Friday. As my sieves, I used average volume, implied volatility as a percentile of the previous rise, and the front-month at-the-money bid/ask spread on call options for the period I'm likely to trade.

AMAT

Volatility

Implied volatility stands at 45%, in the 66th percentile of the prior rise that ended Oct. 16.

Volatility declined sharply from the peak and then hooked up slightly before riding a sideways trend since the start of November.

Options are pricing in confidence that 68.2% of trades will fall between $19.57 and $25.41 over the next week, for a potential gain or loss of 13%.

The Trade

AMAT's price peaked on July 8 at $23.46 and has since executed a series of lower high and a lower low. A decline from the present high would make it another lower high. That pattern is the very definition of a downtrend. In addition, AMAT has a bearish rating from Zacks Investment Research, the service I use to guide my assessment of the fundamentals and Street opinion.

Taking those two facts into account, by bias is toward a post-earnings decline, and my focus will be on setting up a bear play in the form of a bear call spread, sold for a credit and expiring Nov. 21.

AMAT has Weeklys among its options inventory. However, we're in one of those fortunate periods where the regular monthly options are the most reasonable trades, providing greater liquidity and consequently narrower spreads.

My draft trade is structured short the $24 calls and long the $25 calls. This gives me a profitable trade at expiration from $24.14 and downward.

That price level fails to cover the entirety of the one-week range implied by options -- it peaks at $25.41. However, it covers most of the range,

And at any rate, if the price were to move above the prior peak on the chart -- $22.73 on Aug. 29 -- then it would break the downtrending pattern, I would know for a certainty that my trade was on the wrong side of reality, and I would close the position.

The $24 calls have a 75% chance of expiring out of the money, for maximum profit at expiration.

JWN

Volatility

Implied volatility stands at 32%, in the 785th percentile of the prior rise that ended Oct. 16.

Since that peak, JWN has declined swiftly, trended sideways for several weeks, risen a bit and then just on Wednesday hooked downward.

Options are pricing in confidence that 68.2% of trades will fall between $66.17 and $79.53 over the next week, for a potential gain or loss of 9.2%.

The Trade

JWN's price peaked at $73.94 on Nov. 6, fell for three days and has recovered to the upside for two days. It remains below the peak, setting up a potential lower high.

However, at this point I must consider JWN to be continuing within its long-running uptrend, with a bias to the upside. A neutral rating from Zacks dims some of the bullish glitter, so in addition to looking at the bull side when constructing a position, I'll also look at neutral trades that provide protection to both sides of the trade.

A bull position for a high implied volatility trade means bull put spreads. My goal is to protect as much of the downside risk as possible. Options imply a lower one-week range of $66.17 with 68.2% confidence. The previous low on the chart is $70.21, set on Wednesday. A reversal to the downside now and a decline below that level would mean that my bull play is on the wrong side of the market and it is time to skedaddle.

My draft trade then is short the $67.50 puts and long the $65 puts, sold for a credit and expiring Nov. 21. JWN has no Weeklys, so the November monthly contracts are the only choice.

That position would be profitable at expiration down to $67.31, protecting beyond the prior low and nearly all of the options implied range.

Good coverage, but it comes at a cost. The risk/reward ratio is 11:1, far higher than I'm comfortable with. The practical implication of a high risk is that it limits potential profit. I calculate the number of contracts I can by through this process: I divide the maximum I can spend -- 1% of tradable funds -- by the maximum potential loss on the spread -- $229 in the case of this draft trade.

So, $1,000 divided by $229 is 4-1/3 contracts. Being an optimist by nature, filled with irrational exuberance, I round up to five contracts. The maximum profit per contract for this spread is $21. And so my maximum profit is $105.

If the risk/reward ratio were 3:1, then I could trade 16 contracts ($1,000 / 63 = 15.9), for a maximum potential profit of $336 ($21 x 16 contracts).

My draft direction-neutral trade, an iron condor, is short the $77.50 calls and long the $80 calls, and short the $67.50 puts and long the $65 puts.

The resulting risk/reward ratio is much improved, 4.3:1, and the downside protection is greater, to $67.03. The trade-off is expiration above $77.95 would be unprofitable. That upside limit covers most of the range implied by options and is well above the $73.94 peak of Nov. 6, so it is not an unreasonable risk.

The odds of expiring out of the money for maximum profit at either boundary is above 80%.

Decisions for My Account

I shall place both of these trades today and update this analysis after the orders are filled. AMAT was much easier to work with; JWN's open-interest distribution and $2.50 spread between strikes is more difficult to work with. But I judge both trades to have reasonable levels of risk.

-- Tim Bovee, Portland, Oregon, Nov. 13, 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.