Tim Bovee, Private Trader: URBN: Volatility play

Update 11/22/2014: The URBN options spread expired out-of-the-money on Nov. 22 for the maximum (100%) yield on debit.

The shares rose 1.3% over the four-day life of the position, or 120.4% annualized, and the options yield was 3,318.2% annualized.

The Philadelphia, Pennsylvania retail chain Urban Outfitters Inc. (URBN), specializing in young adults clothing and apartment stuff, publishes earnings after the closing bell today, Nov. 17, setting up a potential volatility play. [URBN in Wikipedia]

Volatility

Implied volatility stands at 39%, compared to 14% for the most traded symbol on the U.S. markets, the exchange-traded fund SPY.

URBN's volatility stands at the 91st percentile of the prior rise, which ended Oct. 20 at 40%

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	34.55	38.03	40.67
Lower	27.61	24.13	29.11

Implied volatility 1 and 2 standard deviations; chart support and resistance
Options are pricing in confidence that 68.2% of trades will fall between $27.61 and $34.55 over the next week, for a potential gain or loss of 11.2%, and that 95% between $24.13 and $38.03. The 68.2% confidence level is one standard deviation, and the 95% level is two standard deviations.

The prior move, a downtrend, carried the price from $40.67 down to $29.11, and those are the major resistance levels on the three-year daily chart.

The Trade

The URBN chart shows the price having bounced upward from its low of $29.11 on Oct. 17. Elliott wave analysis suggests the subsequent move will be a run to the upside that will reclaim a portion of the territory lost in the downtrend.

Click on chart to enlarge.

URBN 1 year daily bars

Fibonacci retracement analysis shows that the uptrend since mid-October hit the 23.6% retracement point before falling back a bit. I've most commonly seen retracements to the 38.2%, 50% and 61.8% levels, which on this chart would be $33.53, $34.89 and $36.25 respectively.

The chart truth gives URBN an upward bias that coincides with a bullish rating from Zacks Investment Research, the service I use to short-cut my fundament analysis and for insight into Street opinion.

For a bull trade, I'm looking at bull put spreads, sold for a credit and expiring as soon as I can manage. It's the "as soon as I can manage" hedge that presents the challenge. URBN has no Weeklys in its options inventory, so my choice is to either do an extremely short trade, whose last trading day is next Friday, Nov. 21, or a longer than I like trade expiring Dec. 19.

The ideal trade would be bullish and yet would still provide as much downside protection has possible, suggesting an offset from the at-the-money mark.

I first look at a November expiration that is profitable at expiration down to $28.78, will be profitable if the price is unchanged and remain profitable at all higher prices. That configuration protects nearly all of the one standard deviation range and all of the chart-implied range.

Probability of expiring out-of-the-moneyc Short $28 put, long $26 put expiry NOV

NOV	Strike	%
Lower	29	69.19

Moving to a December expiration would raise my premium considerably, increasing my profit. However, it lowers the probability of expiring out of the money by about 10 percentage points.

The other downside of going so close is that it leaves no time for an "irrationally exuberant" market reaction to the downside to come to its senses and move back up. But my strategy with volatility plays is to take my medicine like a pro if a very short trade goes wrong. (As Evita Peron would have said, "Don't cry for me, Warren Buffett!")

Decision for My Account

I've opened the position for Nov. 21 expiration, as described above. The risk/reward ratio is 4.5:1. It was a bit difficult getting a fill and I had to drop my bid from 22 cents down to 15 cents per contract before the trade would find a seller.

-- Tim Bovee, Portland, Oregon, Nov. 17, 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.