Wednesday, January 21, 2015

LUV: Volatility play

Update 1/28/2015; The stock moved sharply opposite the direction of my position and I've exited for a loss.

Shares rose by 9.0% over the seven day lifespan of the position, or a 1,542% annual rate. The options produced a -234.7% loss on debit, for a -10,707% annual rate.

The world's largest low-cost air carrier, Southwest Airlines Co. (LUV), headquartered in Dallas, Texas, publishes earnings on Wednesday, Jan. 22, prior to the opening bell.

It has Weeklys among its options inventory, and I shall trade the JAN5 series of options, which trades for the last time on Jan. 31, nine days hence.

[LUV in Wikipedia]



Implied volatility stands at 41%, in the 92nd percentile of the rise from 29% on Nov. 26, 2014  to 42% on Dec. 16, 2014.

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

LUV's chart must be viewed through the lens of its competitor DAL, which published earnings Tuesday before the opening bell while displaying a downtrend, and then after the announcement reversed sharply to the upside.

LUV is in a clear downtrend, reversed to the upside on Jan. 16 (Friday), and then reversed to the downside on Jan. 21 (today).

I generally consider the month prior to an earnings release to be the positioning phase, where traders get where they want to be for the announcement. That period began with a rise but in the final two weeks produced a series of lower highs -- a downtrend.

Click on chart to enlarge.
LUV at 9:50 a.m. New York time, 30 days hourly bars
The Trade

Bear call spread, short the $42 calls and long the $43 calls
sold for a credit and expiring Jan. 31
Probability of expiring out-of-the-money


The risk/reward ratio stands at 19:10. The proposed trader covers all of the chart range beyond today's high, which was a turning point, but leaves 2.5% of the one standard deviation range outside of the zone of maximum profit at expiration.

Decision for My Account

As always, I'm going with the chart rather than the story, which means a bear play on LUV. The chattering class has explained the DAL reversal to the upside on Tuesday as being a response to falling fuel prices. Those prices have been falling sharply since June 2014. If that FACT hasn't been priced into the market long ago, then the efficient markets hypotheses is bunk.

The chart suggests that traders may have a more considered response to LUV after Wednesday's earnings announcement. No guarantees, of course, that things will play out that way in fact.

In any case, I've hedged my risk to the greatest extent possible and have opened a bear position in LUV, as described above.

-- Tim Bovee, Portland, Oregon, Jan. 21, 2015


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.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.


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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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