Tim Bovee, Private Trader: GM, MRK: Volatility plays

2/14/2015: GM expired out of the money for maximum profit. The stock rose by 10.5% o er the 11-day lifespan of the poistion, or a 349% annual rate. The optoins position produced a 100% yield on debit, for a 3,318% annual rate.

Update 2/11/2015: I've closed my position in MRK. A gradual decline after earnings were published put it below the profitable range.

The share price fell by -2.3% over the eight-day lifespan of the positon, or a -104% annual rate.

My position produced a -127.3% loss on debit, for a -5,807% annul rate.

Update 2/3/2015; I've opened bull position son both GM and MRK. However, in order to get the probability of success and the risk level right, I moved to the FEB2 series of options, which expires on Feb. 14.

I've updated the initial analysis throughout with new figures to reflect the change in options series.

The automaker General Motors Co. (GM), headquartered in Detroit, Michigan, and the pharmaceutical company Merck & Co. Inc. (MRK), headquartered in Whitehouse Station, N.J., publish earnings before the opening bell on Wednesday, Feb. 4.

Both have Weeklys among their options inventories, and I shall trade the FEB1 series of options, which trades for the last time on Feb. 13, 10 days hence.

[GM, MRK in Wikipedia]

GM

Volatility

Implied volatility stands at 30%, in the 62nd percentile of the rise from 23% on Nov. 25 to 35% on Dec. 16.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	35.69	37.39	34.18
Lower	32.29	30.59	32.36
Gain/loss	5.0%	10.0%

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

Click on chart to enlarge.

GM at 9:45 a.m. New York time, 30 days hour bars

GM has been in a downtrend since 2013. The most recent peak on the near-term chart occurred on Jan. 8. The subsequent decline has been marked by occasional strong counter-trend upswings, the most recent being today after the company announced increased sales.

The directional score, based on the chart and analyst ratings, is 1, arguing for a bull position.

Zacks is bullish, as is the analysts' enthusiasm rating. The upward spike today neutralized the longer-term downtrend score, moving GM into bull territory.

I looked at historical impacts of earnings on prices five days after the announcement. I found an even split. Half of the last four earnings announcements saw prices open above the pre-announcement open after five days, and half opened below, for an impact score of zero.

The Trade

Bull put spread, short the $33 puts and long the $32 puts
sold for a credit and expiring Feb. 14
Probability of expiring out-of-the-money

FEB2	Strike	%
	33	69

The risk/reward ratio stands at 4:1.

MRK

Volatility

Implied volatility stands at 24%, in the 87th percentile of the rise from 16% on Nov. 26, 2014 to 26% on Dec. 16, 2014.

Ranges implied by options and the chart

Week	SD1 68.2%	SD2 95%	Chart
Upper	62.98	65.43	62.96
Lower	58.08	55.63	59.78
Gain/loss	4.1%	8.1%

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

Click on chart to enlarge.

MRK at 10:20 a.m. New York time, 30 days hourly bars

MRK hit a major peak on Jan. 13 and has since been declining, with the fall accelerating from Jan. 28.

The directional score, based on the chart and analyst ratings, is 1, arguing for a bull position. It was today's rise that pushed the directional score into bullish territory. Zacks is neutral and analysts are positive.

The earnings impact score, which compares the opening price five days after the announcement with the opener the session before the announcement, is +2 out of a maximum positive score of +4. Three of the past four earnings announcements have produced price rises, and one a price decline.

The Trade

Bull put spread, short the $60 puts and long the $59 puts
sold for a credit and expiring Feb. 14
Probability of expiring out-of-the-money

FEB2	Strike	%
	60	63

The risk/reward ratio stands at 3:1.

Decision for My Account

See the update at the top of the post. Here was my original decision:

I'm not happy with either trade The grids make it impossible to get a sufficiently low risk/reward ratio with a sufficiently high probability of expiring out of the money for maximum profit.

The risk/reward ratios are high -- 3:1 for GM,which is acceptable but on the high side, and 4:1 for MRK, at the limit of acceptability. The probabilities of expiring out of the money for maximum profit is below the one standard deviation mark and in both cases would leave significant portions of the ranges uncovered.

I'll look at these again later in the trading day and post an update with my decisions,

-- Tim Bovee, Portland, Oregon, Feb. 3, 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".

The directional score is calculated as the sum of the following:

Zacks rating --The Zacks ratings are translated as follows: 1=2, 2=1, 3=0, 4=-1 and 5=-2.
Enthusiasm rating --: A single percentage derived from the number of analysts whose opinions are in one of five categories: Strong buy, buy, hold, sell and strong sell.
Strong buy share -- The percentage of all analysts who rank the stock strong buy. If the share is 60% or greater, the score is 1; if 40% or less, then the score is -1; otherwise, the score is zero.
Ethusiasm momentum -- The score is 1 if today’s enthusiasm rating is larger than the rating 30 days earlier; otherwise, the score is zero.
30-day direction -- The trend that best describes the 30-day chart: 1 for an uptrend, -1 for a downtrend and zero for a sideways trend.
One-day direction -- The trend that best describes the one-day chart: 1 for an uptrend, -1 for a downtrend and zero for a sideways trend.

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.