Tim Bovee, Private Trader: MRVL, ZOES, GME: Volatility plays

I'm looking at three potential trades under my very short term volatility. All will publish earnings after the closing bell today, Nov. 20. The companies are:

Marvell Technology Group Ltd. (MRVL), a maker of semiconductors designed for specific applications, headquartered in Santa Clara, California,
Zoës Kitchen Inc. (ZOES), a restaurant chain serving a Mediterranean/Southern fusion menu, based in Plano, Texas, and
GameStop Corp. (GME), a video game retail chain based in Grapevine, Texas.

[MRVL, ZOES, GME in Wikipedia]

MRVL

Volatility

MRVL's implied volatility stands at 40%, compared to 14% for the S&P 500, and is in the 63rd percentile of its move to the recent peak of 49% on Oct. 13. Since then, after an initial steep decline, it has settled into a sideways movement with a slight downward bias.

The range implied by option pricing wide enough to contain 68.2% of trades provides the potential for a 5.6% gain or loss over the next week. The range that by implication would contain 95% of trades has a maximum potential profit or loss of 11.8%.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	$14.01	$14.75	$14.25
Lower	$12.53	$11.79	$11.65

Implied volatility 1 and 2 standard deviations; chart support and resistance
The Trade

The chart shows that MRVL is in a counter-trend movement within a larger downtrend, and is engaged in a sideways correction within the counter-trend. Think of it as a collection of nested Russian dolls, Darya Downtrend on the outside, open it up to discover Ulyana Uptrend, and open that up to find the smallest of them all, Svetlana Sidewinder.

Looking closer, prices have gone nowhere day to day of the past three days. Intraday, the net has been up, down, up for the three days.

The bottom line here is that I can't pick a direction, so any viable trade would need to be agnostic as to direction: An iron condor.

MRVL has Weeklys among its options inventory, so I'll be looking first at those expiring Nov. 29. The calls give me three strikes out of the money with triple-digit open interest, but the puts give me only one.

This makes it impossible to put together the puts portion of a position, since I need both a short strike and a long strike, each with triple-digit open interest. It doesn't exist.

I can fudge on the put side, using the $12 strike, with open interest of 85, for the long puts. But it does break one of my rules.

Even at that, the resulting range is fairly low probability on the lower side, only 63.61% and leaves a large portion of the ranged unprotected, both the one standard deviation and two standard deviations ranges, as well as the range imposed by support and resistance on the chart.

On the positive side, the risk/reward ratio is quite good, at 2.6:1.

Probability of expiring out-of-the-money iron condor, sold for a credit and expiring Nov. 28 short the $14 calls and long the $14.50 calls, short the $13 puts and long the $12 puts

NOV4	Strike	%
Upper	$14	72.26
Lower	$13	63.61

ZOES

Volatility

ZOES' implied volatility is 68% and stands in the 71st percentile of the uptrend that ended Nov. 4 at 77%.

Options are pricing in confidence that 68.2% of trades, in the one standard deviation range, will incur a maximum potential profit or loss of 9.5% over the next week, and 95% of trades, the two standard deviation range, will see a potential gain or loss of 18.9%. That's a fairly high degree of volatility. (A good thing, since Volatility is the mother of Profit.)

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	$36.33	$39.47	$38.42
Lower	$30.05	$26.91	$27.09

Implied volatility 1 and 2 standard deviations; chart support and resistance
The Trade

The most glaring fact about a trade in ZOES is that the options inventory lacks Weeklys. The shortest-lived trade I can build will expire Dec. 20, which is 30 calendar days hence.

The price has been in a strong downtrend beginning Oct. 31, although at a smaller degree of resolution, there was a bounce to the upside from Nov. 13. It stalled on Nov. 17 and has been meandering sideways until today, which produced a sharp movement to the upside (marked by a yellow oval on the chart).

On the basis of that one-day move, I would play ZOES as a bullish trade if it were a position with a shorter lifespan. But for a 30-day trade, as is required by the lack of Weeklys, I would tend to go direction neutral with an iron condor

However, the open interest distribution is such that the best I can manage for a high-probability trade carries an 11.5:1 risk/reward ratio. That's far higher than I'm willing to contemplate. Normally, I dislike going over 4:1.

I can get n excellent 1.8:1 risk/reward ratio by lowering the probability of expiring out of the money to 64.08% on the upper side and 68.82% on the lower side, Is the lower probability a good exchange for the improved risk/reward ratio? That's the question I must answer

Higher probability of expiring out-of-the-money iron condor, sold for a credit and expiring Dec. 20 short the $40 calls and long the $45 calls, short the $25 calls and long the $22.50 calls

DEC	Strike	%
Upper	$40	87.78
Lower	$25	88.13

Lower probability of expiring out-of-the-money iron condor, sold for a credit and expiring Dec. 20 short the $35 calls and long the $40 calls, short the $30 calls and long the $25 calls

DEC	Strike	%
Upper	$35	63.75
Lower	$30	68.90

Click on chart to enlarge.

ZOES 20 days 10-minute bars

GME

Volatility

Implied volatility stands at 66% and lies within the 95th percentile of the rise that culminated Nov. 7 at 68%.

GME is pricing in confidence that the one standard deviation range, encompassing 68.2% of trades, will provide a potential gain or loss of 9.2% over the next week, and the two standard deviation range, covering 95% of trades, will provide a potential gain or loss of 18.4%.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	$48.61	$52.71	46.59
Lower	$40.43	$36.33	33.10

Implied volatility 1 and 2 standard deviations; chart support and resistance

The Trade

GME also cries out for a range-bound trading strategy, an iron condor. I think I'm seeing a theme for the present state of the market.

The price came down from its November 2013 peak in a zig-zag that ended in February 2014. It has since entered a sideways period that has so far completed four legs, and is now in its fifth leg, to the upside.

Macro level, GME is in a sideways correction to a counter-trend move to the upside within a downtrend.

Micro level, it is in an uptrend within a sideways movement.

And at a really small degree, it has been trending sideways for the past six days, with intra the first two showing net rises intra-day and that final four showing net declines intra-day.

The chart ranges shown in the "Volatility" section mark the breakout levels beyond the boundaries of the sidewinder.

GME's options inventory carries Weeklys, which means I can construct very short term trade. The open interesting distribution is excellent, with the strikes spaced 50 cents apart for maximum granularity. This is an options grid that could inspire an iron condor trader to fall deeply in love.

I'm able to put together an iron condor with the short strikes on both sides with probabilities of expiring out of the money of 79% on the upward side and 77% on the downward side, both of which are quite good.

The range of profitability falls a bit short in its coverage to the downside of the one standard deviation range, and a bit short to the upside on the chart resistance range.

The risk/reward ratio is acceptable, at 3:1. I could increase the range of coverage, but only at the price of increasing the risk/reward ratio to greater than 5:1. The narrower coverage still gives me three days worth of the average true range to the upside, and five days to the downside, which I judge to be adequate.

Probability of expiring out-of-the-money iron condor, sold for a credit and expiring Nov. 29 short the $48 calls and long the $48.50 calls, short the $37.50 puts and long the $35.50 puts

NOV4	Strike	%
Upper	$48	78.99
Lower	$37.50	77.20

Click on chart to enlarge.

GME 2 years daily bars

Decision for My Account

I dislike MRVL for the limitations imposed by its open interest distribution and I find that ZOES lacks flavor because of the lack of Weeklys forces me into a longer lived trade than I like.

That leaves GME -- great grid, awesome open interest distibution, perfect risk/reward ratio. But there is trouble in paradise.

The bid/ask spread on the position I built ranges from a ludicrous 1 cents to 44 cents. I've don my usual negotiating to try to get a decent fill, but to no avail.

I judge that in order to get a fill on my order, I would need to drop my ask down to the 25 cent area, cutting deeply into my profit potential and raising the risk/reward ratio to 7:1.

I'm unwilling to go that far, and so I am abandoning the trade. I don't plan to open positions on any of the three symbols analyzed in this report.

Bummer! But as traders, we can only go where the numbers lead us.

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