Tuesday, December 9, 2014

COST: Volatility play

The global warehouse retailer Costco Wholesale Corp. (COST), headquartered in Issaquah, Washington, publishes earnings prior to the opening bell tomorrow, Wednesday, Jan. 10. [COST in Wikipedia]


Implied volatility stands at 19%, which is in the 63rd percentile of its rise from Aug. 20 to Oct. 15. Volatility declined in mid-October and since has traced a largely sideways path with a slight uptrend.

The one standard deviation confidence range, encompassing 68.2% of trades over the next week, implies a potential gain or loss of 2.7%, and the two standard deviations range, encompassing 95% of trades over the period, implies a 5.4% gain or loss.

Ranges implied by options and the chart
WeekSD1 68.2%SD2 95%Chart
Implied volatility 1 and 2 standard deviations; chart support and resistance

The Trade

The chart has been downtrending since peaking Dec. 5. I judge it to be in a downtrend. The Nov. 24 low of $138.50 marks the nearest resistance to the downside, albeit minor.

Click on chart to enlarge.
COST 20 days 30-minute bars
Looking at the JAN1 series of options, which expires Jan. 2, 2015, I find that the open interest distribution limits me to one choice in structuring a bear call spread, and I can only make that work by ignoring one of my preferences, since the open interest is in the double digits, and I generally require triple digits or better.

Bear calls spread, short the $147 calls and long the $148 calls
sold for a credit and expiring Jan. 2, 2015
Probability of expiring out-of-the-money

Open interest on the short leg is quite high, at 913, but on the short leg it is only 39.  Strikes higher than $148, the long leg, have open invest of zero, so a dollar wide is the best I can do with this grid.

The structure covers all of the one standard deviation range and the chart range in both directions. it leaves 18% of the two standard deviation range uncovered.

The risk/reward ratio is 3.5:1.

Decision for My Account

I shall attempt the trade. The impact of the low open interest on the long leg would be to make it difficult to get a fill, requiring me to lower my ask price. I won't lower it by much. If I can get the fill, then the trade will go through.

And indeed it did, requiring me to lower by only one cent.

-- Tim Bovee, Portland, Oregon, Dec. 4, 2014


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. 

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.

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Based on a work at www.timbovee.com.

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