Tim Bovee, Private Trader: SWHC, FNSR, BIG: Volatility plays

Update 12/9/2014: FNSR rose sharply after earnings were announced and today hit the point where it would no longer be profitable at expiration. The rise was large enough to persuade me that I should exit, and I've done so, taking a loss.

Shares rose by 6.9% over the five-day lifespan of the position, a 501.5% annual rate of change. The options produced a 100% loss on debit -- their value was halved -- for a -7,300.00% annual rate of change.

Update 12/8/2014: BIG dropped sharply after earnings were announced, much to the benefit of my bear position. I've exited, 12 days prior to expiration, as the value of my options dropped to near zero the point of maximum profit.

Generally, my practice is to get out if the value drops below 5 cents a contract. That final nickel is very little reward for much potential risk.

The shares declined by 13.5% over four days, or 1,248.4% annualized. The options produced a 95.25 yield on debit, or 8,683.47% annualized.

I'm considering three companies for volatility trades keyed to earnings announcements.

Two publish quarterly results after the closing bell today, Dec. 4: The Springfield, Massachusetts firearms manufacturer Smith & Wesson Corp. (SWHC) and the Sunnyvale, California maker of optical subsystems for communications Finisar Corp. (FNSR).

Another publishes before the opening bell on Friday, Dec. 5: The Columbus, Ohio closeout retailer Big Lots Inc. (BIG).

[SWHC, FNSR, BIG in Wikipedia]

All three lack Weeklys in their options inventories, so I'll be looking at the monthly series expiring Dec. 19 (DEC series) as my first preference, with the Jan. 15 expiration (JAN series) as my backup.

SWHC

Volatility

Implied volatility stands at 56%, compared to 13% for the S&P 500, and is in the 95th percentile of its prior rise that peaked Nov. 21 at 57%.

The one standard deviation range of confidence, encompassing 68.2% of trades, implies a potential gain or loss of 7.8% over the next week.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	10.31	11.05	10.87
Lower	8.31	8.07	9.03

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

The SWHC chart shows it as being clearly in a downtrend within a downtrend, suggesting that the position should be structured as a bear call spread,

Click on chart to enlarge.

SWHC 80 days hourly bars

The only reasonable construction on the SWHC options ride is to use the $11 calls for the short leg of the trade ad the $12 calls as the long leg for insurance. And that presents a problem.

Both the December and January options produce a risk/reward ratio of 13:1, which is way too high for my taste. The table below uses the JAN series as the illustration, but the DEC series is quite similar.

Bear call spread, long the $11 calls and short the $12 calls sold for a credit and expiring Jan. 15 Probability of expiring out-of-the-money

JAN	Strike	%
	11	81.77

FNSR

Volatility

Implied volatility stands at 51%, within the 71st percentile of the rise to the Nov, 13 peak of 55%.

The one standard deviation range of confidence, encompassing 68.2% of trades over the next week, implies a potential gain or loss of 7.1%.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	18.44	19.67	17.70
Lower	15.98	14.75	15.88

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

The Trade

FNSR on Nov. 21 completed an upward correction within a larger downtrend, and I consider a bear call spread to be the best vehicle for a trade. A price move above $17.70 would negate this assessment as it would indicate that the upward correction was still underway.

Click on chart to enlarge.

FNSR 30 days hourly bars

Bear call spread, short the $18 calls and long the $19 calls sold for a credit and expiring Dec. 19 Probability of expiring out-of-the-money

DEC	Strike	%
	18	69.60

The trade described above provides a 4:1 risk/reward ratio, the the highest I consider to be acceptable.

BIG

Volatility

The Nov. 28 peak, $51.75, ended a large-scale uptrend, and the chart shows a subsequent sharp decline as the price moved into a downtrend. The sideways movement in early December marked a pause in the decline, but the downtrend remains in force.

The question is whether the sidewinder is complete. Only a decline below the Dec. 1 low of $47.14 can resolve that question. The implication for the position is that, while being bearish, it must have a range of profitability that covers as much above the $49 level as the options grid will allow.

Click on chart to enlarge.

BIG 10 days 15 minute bars

The only possible out-of-the-money position allowed by the open interest distribution is short the $50 calls in the DEC series, expiring Dec. 19. This provides an acceptable 2.7:1 risk/reward ratio

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	51.13	54.16	48.78
Lower	45.05	42.02	47.14

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

The Trade

The DEC series, expiring Dec. 19, provides a 10.4:1 risk/reward ratio if I provide protection up to $52.50. That's far too high for my taste. The probability of expiring out of the money for maximum profit is 84%, which is quite high.

Dropping down to a $50 short leg reduces the OTM probability to 69%, but also reduces the risk/reward ratio to 2.7:1.

Bear call spread, short the $50 calls and long the $52.50 calls sold for credit and expirting Dec. 19 Probability of expiring out-of-the-money

DEC	Strike	%
	00	00.0

The JAN series, expiring Jan. 15, increases the time risk but also helps the OTM probability up to 78%, a significant gain. The risk/reward ratio is acceptable, although barely, at 4.3:1.

Bear call spread, short the $50 calls and long the $52.50 calls sold for credit and expiring Jan. 15 Probability of expiring out-of-the-money

JAN	Strike	%
	52.50	78.47

Decisions for My Account

I'm passing on SWHC because of the impossibility of getting a reasonable risk/reward ratio. I opened a position in FNSR as described above. I've also opened a DEC series trade in BIG, as described above.

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