Tim Bovee, Private Trader: BAC, C: Volatility plays

Update 1/23/2014; I've closed C as it slipped slightly in the on the last trading today before the options expire.

The shares rose by +1.2% over the nine-day lifespan of the bear position, for an annual rate of +50.2%. The options produced a +34.4% yield on debit, for a +1,394.1% annual rate.

Update 1/14/2015: I've updated the C portion of the post, including the chart, with the trade I actually took.

Update 1/14/2015: I've opened a position in C. A price decline required me to restructure the trade as long the $49 call and short the $50 call. I'll update with details later in the trading day.

Note: Due to a scheduling conflict, I am doing this analysis prior to Wednesday's opening bell. I shall place any trades based on the analysis immediately after the opening.

Two large banks, Bank of America Corp. (BAC), headquartered in Charlotte, North Carolina, and Citigroup Inc. (C), headquartered in New York City, publish earnings Thursday prior to the opening bell. [BAC, C in Wikipedia]

Both have Weeklys in their options inventory, and I shall be working with the JAN4 series, which expires nine days hence.

BAC

Volatility

Implied volatility stands at 29%, in the 68th percentile of the rise from 18% on Nov. 24, 2014 to 34% on Dec. 16, 2014. The December peak was followed by a steep fall and an upside retracement that fell short of setting a higher high. It has since resumed movement to the downside.

The one standard deviation range surrounding the current implied volatility and encompassing 68.2% of trades suggests a potential gain or loss of 4.5% between Wednesday and the expiration of the JAN4 series on Jan. 26, and the two standard deviation range, covering 95% of trades, a gain or loss of 9.0%.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	17.19	17.93	17.38
Lower	15.71	14.97	16.32

Implied volatility 1 and 2 standard deviations; chart support and resistance
BAC has been on a rise since Dec. 2011 as part of an upside retracement from the 2009 Great Recession low. It is near resistance at the peak of the first wave up from that low and has tested the upside twice in what could be interpreted as the beginning of another trip to the cellar.

Near term, the price began a sharp decline from Dec. 31 and hit a fresh low on Tuesday. I've used that low as the lower boundary of the chart range and an interim retracement peak within the larger decline from January as the upper boundary.

The trend is clearly to the downside.

Click on chart to enlarge.

BAC 30 days hourly bars

The Trade

Bear call spread, short the $17 calls and long the $18 calls sold for a credit and expiring Jan. 26 Probability of expiring out-of-the-money

JAN4	Strike	ITM
	17	74.17%

Because of the low share price, BAC's options grid provides a low credit, which requires more contracts to make the trade worthwhile and therefore increases the cost of the trade.

The low price also increases the impact of the 50 cent spread between strikes, so that the odds of expiring in-the-money for maximum profit drops for 74% when short the $17 strike to 54% when short the $16.50 strike. I always want to have at least a 60% chance of expiring ITM.

The impact of the relatively high ITM chance is a high risk/reward ratio of 8:1. My preferences allow a maximum of 4:1.

The proposed trade above covers most of the one standard deviation range and the chart range.

C

Volatility

C's implied volatility stands at 34%, in the 100th percentile of the rise from 18% on Nov. 13, 2014 to 33% on Jan. 7. The form of the implied volatility trace is similar to BAC's -- big rise, big decline and a fresh rise. The difference is that C's fresh rise attained a higher high. In terms of my form preference, C's is superior.

The one standard deviation range implies a potential gain or loss of 5.4%, and the two standard deviation range, a gain or loss of 10.8%.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	51.12	53.72	51.23
Lower	45.90	43.30	48.51

Implied volatility 1 and 2 standard deviations; chart support and resistance
C's chart showed a precipitous drop from 2006 to 2009 and has since traced a meandering sideways path. The price is presently at the upper end of the range, having pulled back from a a December peak that pushed out the upper range of the sideways trend.

Click on chart to enlarge.

C 30 days hourly bars, snapshot at ~1:15 p.m. New York time

The decline from that peak has traced out a series of distinct waves, with the trace presently in the 3rd wave down. The most recent low, $47.86, is above the $45.18 lower boundary that has contained the movement since 2011. Wednesday's precipitous price drop has brought that level within easy range.

The most recent step of the decline is contained entirely in two days, Jan. 13-14 -- a peak and a decline. An alternate upper boundary of the chart range would be the Jan. 9 peak of $52.24.

In either case, the C chart is in a downtrend.

The Trade

Bear call spread, short the $49 calls and long the $50 calls sold for a credit and expiring Jan. 26 Probability of expiring out-of-the-money

JAN4	Strike	ITM
	49	~65%

The best coverage the options grid for C will leaves 3.7% of the chart range and 3.5% of the one standard deviation range unprotected in case of a reversal to the upside.

I did not capture the likelihood of the position expiring in the money for maximum profit, but I recall it as being about 65%, which is acceptable. is acceptable, as is the 27:10 (slightly under 3:1) risk/reward ratio.

Decision for My Account

The proposed trade for BAC has an unacceptable risk/reward ratio and I shall not open a position.

The proposed trade for C is acceptable and I opened a position as described above five minutes after the opening bell on Jan. 14.

-- Tim Bovee, Portland, Oregon, Jan. 13-14, 2015

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.

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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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.