Monday, January 12, 2015

AA, KBH: Volatility plays

The new earnings season kicks off with publication after the closing bell today, Jan. 12, by the aluminum company Alcoa Inc. (AA), headquartered in Lever House in New York City, followed by the builder KB Home (KBH), headquartered in the Westwood neighborhood of Los Angeles, California, before the opening bell on Monday, Jan. 13. [AA, KBH in Wikipedia]


I can reject AA as a play immediately because of its relatively low annual implied volatility at 40%. By "relatively" I mean in terms of its position relative to the most recent large trend from base to peak.

In AA's case, that trend began Nov. 26, 2014 from 32% and peaked on Dec. 16, 2014 at 53%.

Applying the formula,

(current - base) / (peak - base)

and expressing volatility as decimals with four digits of precision, I get 0.3952. Multiplying that by 100, I get a percentile of 39.52, rounded to the 40th percentile and meaning that implied volatility at present is 40% of the way from the base to the peak of that prior trend.

My rules require the 60th percentile or greater in order to give more room for the volatility to collapse after earnings.

AA fails that test.



KBH has implied volatility of 44%, which is in the 75th percentile of the range peaking Dec. 17, 2014 at 48%.

The next available options are the monthly issue expiring Feb. 20, which is 39 calendar days away.

The one standard deviation range surrounding implied volatility, encompassing 68.2% of trades in those 39 days, suggests a potential gain or loss of 18.9%, and the two standard deviation range, covering 95% of trades, of 28.9%

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

On the chart, KBH has been tracing a downward path in a series of wide-swinging zig-zags from its $25.14 peak set May 14, 2013. The lowest low so far attained is $13.75 on Oct. 13, 2014.

Since then, the price has swung up in three waves, peaking at $18.08 on Nov. 25, 2014, and declined in a downward wave, and an upwave making a partial retracement.

The next major move will obviously be a downward push, even though the very near term trend is presently upward.

Click on chart to enlarge.
KBH 90 days 4-hour bars (left), 3 days 15-minute bars (right)
I have taken more time with this chart analysis and enlisted Elliott wave analysis to aid me because of the ambiguity of the trend.

The right-hand chart -- the longer term -- clearly shows KBH in a wave 2 correction to the upside within a larger downward trend. The shorter term chart on the left shows that the upward correction has faltered and is moving to the downside.

The longer-term trend carries greater weight because it is less subject to the randomness of the markets. The shorter-term trend carries significance as a canary in the coal mine, a harbinger of things to come.

The Trade

The downward scenario of the shorter-term chart borrows credence from KBH's rating from Zacks Investment Research, the service I use as a short-cut into the financials and the expectations on The Street. Zacks has given KBH a bearish rating.

One solution would be to make an agnostic trade, using an iron condor. However, that simply limits profit in both directions, setting up the possibility of loss no matter which way the price moves. Taking a directional stand at least gives me clear sailing in the direction of my choice.

Bear call spread, short the $18 calls and long the $19 calls
sold for a credit and expiring Feb. 20
Probability of expiring out-of-the-money

Only three February strike prices have open interest in the three figures or better, a reality that guides my construction of the trade.

Decision for My Account

The KBH trade proposed above covers all of the chart range, and covers 96% of the one standard deviation range. The 75% chance of expiring in the money for maximum profit is quite good.

On the other hand, the 9:2 risk/reward ratio is larger than I like.

Worst of all is carrying the risk for 39 days. My ideal period for a volatility play is two weeks, with three weeks being acceptable. This is more than 5-1/2 weeks. KBH lacks Weeklys in its options inventory and so provides no alternative.

The lifespan of the trade is a deal killer for me. I shall pass on KBH, and I have passed on AA due to relatively low implied volatility.

-- Tim Bovee, Portland, Oregon, Jan. 12, 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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