(Insert British accent and minstrel music here)
Once upon a time there was a story blog called All-Star Trades. One of these blogs was about a fearless knight, named Anyway, who sought to make riches in the land far and wide.
Although brave, Anyway was not experienced in all the ways of the financial world, and as such he was still learning and making his way in the Option Kingdom. He trudged through the hills as a young warrior. On his coat of arms he bore a calendar spread, one of the few tools in his arsenal. He sought to gain more knowledge and experience, so he set off to battle a goliath of an opponent - a larger than life figure. We shall call him Stearns, Mr. Bear Stearns.
Whilst Anyway was out on his journey, he arrived in a town called March Expiration where he encountered a couple of Mr. Stearns' ruffians. Their names: Volatility and Bankruptcy. These hooligans had been stirring up trouble shortly before Anyway arrived, but he paid them no attention. His cavalier attitude assured him that he and his calendar spread would prevail. The day was March 14. Two days later, while preparing for the next day's battle on March 17, doubt started to creep into Anyway's seemingly impervious mind. While he lay awake recounting the events of the day's battle, he realized his strategy may not be a foolproof as he once thought. He was overcome with a need to record the events for his fellow compatriots back home.
Too much Time (Value) on my hands
I posted a calendar spread trade on Bear Stearns (long call 1, short call 1, long call 2, short call 2)
"Sold the March 30 calls, bought the Jan 09 30 calls, debt of 4.70. Seems like owning a Jan 30 call for cheaper than just outright buying the call (the time value for 8 days was only 4.70 less than the time value for 300 some days)" - Anyway calendar spread entry on March 14
and asked for feed back on what could go wrong received some good comments (but not the answer I was looking for) what was I missing? Then it hit me. I had oversimplified the equation Option Value equals Intrinsic Value and Time Value. The Implied Volatility of BSC is so high that when I thought I was selling time value in the March Calls I was actually selling mostly volatility value. When I bot the Jan09 calls I was actually buying time value I thought pretty cheap. I knew BSC could go to zero and I was willing to take a position that they wouldn't in 8 days. But without thinking it completely through I was betting all the time value I was paying for that they wouldn't be bought out by then either. If the deal is done and the price is set wouldn't time value for all options go to zero? 3/16/08 9:52pm
From nowhere, a pixie materialized before his face in midair. She was engulfed in soft light and smiled encouragingly at the knight. She spoke softly with a muted but friendly Irish accent, "I will answer all of your concerns Sire, but I must call upon the wisdom of the universe to assist me. Shield your eyes while I engage my magical TradeKing powers." The pixie donned a pair of radiant, oversized gold spectacles. She took a deep breath and then spoke once more, but this time with a different accent, an accent from a far away land - from the Brook of Lyn...while chewing gum.
"Your logic is a little flawed, but don't sweat it" she winked. "To be more specific, you were selling volatility skew, with March trading near 500 IV and Jan 09 trading for 124 IV. You have gotten the larger point that there was more going on than just selling fat, juicy premium in March. You are correct - if there was a take over, the options go to mostly intrinsic value, and time value goes out the window (mostly to zero). If the certainty of the deal going through begins to diminish, the time value would begin to increase again and slowly return."
Anyway, startled at first, decided to engage the pixie further.
It's like I set down at a casino table and knew the dealer had 16 I thought we were playing 21 and that I had an obvious advantage. Turns out he had pocket 8's and we were playing Texas Hold'em. I may still win the hand but I really didn't know what game I was playing. 3/16/08 9:52 am
The pixie responded, "That's it in a nutshell. But I know neither are fun when you are the one who don't know the game. Your original thoughts were correct, like your paisano Mr. McMillan said. You saw the potential in selling high volatility and high time premium. The thing you didn't see or stop to ask until now was ‘why are these options trading so high?' The amount or degree of skew between two months IVs is usually a good indicator of pending news. This pending announcement may be scheduled (earnings) or unscheduled (merger / bankruptcy). The larger the difference between the two months, the more drastic move the underlying is expected to make. This move can be in either direction and is not determinable from skew. A pixie friend of mind, actually a pixo since he's a guy and not a girl like me, discusses this in a recent post on Volatility Tilt. His name is Brian Overby. You should get on that for next time. You don't want to be caught with your 'armor down' again. That is if your pops doesn't revoke your internet privileges. I think I can smooth things over for you if it's a problem," she smirked while twirling her wand.
Anyway, still reeling from the wisdom just bestowed on him from the pixie, was startled once again. This time by a magical snowman, shuffling cards in an arch formation above his top hat. The unmelting snowman spoke.
That is the beauty of the game. You are in a position, do not know why, yet you are not sure. Play it to the end 5 days and you will find out. Fold and you may take a loss. I did not see anyone bidding it up in aftermarket when the news was out! So right now it looks like you are holding three of a kind. Deals take more than a week to announce. So what if the other guy has a couple of eights? 3/16/08 3:47 pm
The group's meeting was interrupted once more. This time by a beeping sound, coming from Snowman's carrot nose. Snowman removed his nose, revealing that it had an electronic display with news wire headlines running across it. He turned the electronic carrot towards Anyway and explained...
Check CNN for news, not good. 3/16/08 4:49 pm
Anyway read the article and exclaimed...
I hate it when I get beat on the river card. Or was I beat on the flop? It will be an education to watch this all play out. An expensive lesson learned. Shall I turn off the ROI part of my post? I hate bad reminders looking at me. At least I didn't bet the farm. At least I sold the March calls. Wonder how financial stocks will respond to that buyout price? I think the value of their building was estimated at over 5 times that.
Anyway turned to the pixie and asked...
What's the opposite of an ALL STAR TRADE?
Now cracking her gum, the pixie responded, "Before you get all jacked up about all this, let's take a look at what really happened. When were you beat? You were beat when you sat down to play poker and ponied up money on Bear Stearns. Bad numbers laughing back at you? Tell me about it! Believe you me, there is only way to triumph over all this. Use those negative numbers to your advantage, to compete against, to keep you in line, to remind you to do your homework before placing a trade, whatever it takes to prevent this misstep from happening again.
"What did you do right? Not betting the farm is a great thing and you should be recognized for it. Too many times have I been summoned by the heavens to console people after a blow up like this, except many of them were not so lucky as you. They ploughed money they had no business using into this kind of "free money" opportunity/deception. Be thankful you are taking the hit, but you can keep on ticking. Selling the March calls definitely reduced your capital exposure and helped you in a bad situation as compared to buying the leaps outright. However, you should not have entered into a double down situation with a double calendar spread. As calendar spreads are constructed away from the at-the-money strike, they become cheaper. If you decide to trade a calendar in the future because it is cheaper than buying the calls outright, remember that your forecast must include the stock moving toward or staying near the strike you have sold. Without this last piece you still would lose money in the position.
"I must say it is ironic about asking about the All-Star trade, as Mr. McMillan's post did not come out until the next day, nor had either of us seen your blog posts over the weekend. Sometimes you just got to shake your head, laugh at the situation and yourself, and move on. There really is no other choice, right?"
Snowman, nose now back in place, chimed in...
That was a complicated trade. I lost when I first started trading too. It takes time and patience. Every time I try to play with take over stocks like Yahoo I end up losing. You picked a tough one! 3/16/08 8:37 pm
The next day, Anyway accepted his defeat from the mighty and unpredictable Bear Stearns. He recounted his actions once more. The Brooklynite Pixie and ever frozen Snowman were still in tow to listen as he spoke.
As you can see by my posts over the weekend. I felt like the trade was too good to be true but I couldn't put my finger on it til I woke up Sunday morning 3 am and realized what if the deal is done over the weekend and all the volatility is gone in one swoop. Then to read the headlines Sunday evening.......... , still $2 / share seems low with the Fed assuming so much or all of the risk. Hope the big shareholders squawk about the price.
Just a quick question. Wouldn't the ultimate outcome have been similar for a calendar put spread at the same strike prices?
The pixie once more bequeathed her insight. "Exactamundo! A horizontal calendar spread (when both strikes are equal in price) done right is less about using calls or puts, and more about using a strike price to match your forecast. Remember what I said to you last night about ‘What did you do right?' Make sure you fully understand it. Get back to me later if you don't. Remember that pixo friend I have? Brian Overby? He has another series on Calendar Spreads. He's a sharp guy, even if he is a bit tall for a pixie at six-foot-four."
Anyway smiled and inquired more.
Since, I have paid the market for this lesson. I'll ask even another question. If the stock had stayed between 25 and 30 til the March calls expired worthless. Bringing their volatility to zero, wouldn't I be able to keep the long Jan position and write the April calls same strike for no additional margin or cost and could have reduced their original cost by the total premium received (and if volatility stayed in the 80's for the April could have owned the Jan at a credit?) I know this is a what if question for this stock but there are some pretty high nearby volatility premiums out their on other stocks. If you have time could you do this evaluation on WB April and Jan09 calls. I want to make sure I'm looking at it correctly now.
The pixie responded, "If the stock stayed between 25 and 30, the 25 calls would have gone out (at expiration) in the money. Assuming you did not close the position you would have been assigned on the short 25 calls and sold the stock at 25. What happens after that depends on how much cash you have in your account - either holding the short stock or closing out the stock and deciding to sell the April calls against the Leaps you would still be holding.
"As for the 30 calls, yes these would have expired worthless. Yes, you can keep selling against the Jan calls, eventually reducing their cost basis, or maybe even making it a credit. You asked some good questions about premium, but don't forget about volatility skew and volatility tilt. You need to consider these items especially during these extremely volatile times. Skew and tilt are also specific to each stock. Some stocks (their options actually) will hold varying degrees of skew leading up to some news event. The only way you can get a feel for something like this is by recording the information you see, when you see it, and comparing it to future observations.
"In the case of BSC, the skew you were trying to capture was nearly 376 percentage points (or clicks for short) because March was trading around 500 IV and Jan 2008 was trading around 124 IV. Regardless of stock, I can safely make the assumption that this difference is extreme in just about any situation I have seen."
For emphasis, the pixie grabbed Snowman's nose, made a few touches on its screen and showed Anyway her findings.
Click here for a larger image.
"Before every trade, even a stock trade, you may want to look at the volatility chart first. It may not guarantee that you'll come out a winner, but at least you will know the forecast before heading into battle. We call that ‘throwing down' where I come from. You can find it on the TradeKing site under Quotes+Research > Volatility Charts. Had you looked first, you would have seen that the average historical IV was in the 50s, not the 80s, 100s, or 200s like we see here. Something must be going on to cause such a spike in IV. Seeing this might have alerted you to research the traits of the calendar strategy more closely. And also see how it would fare under these crazy volatility conditions. To conduct a ‘What If' analysis, simply go to Tools > Profit+Loss Calculator. Here you would enter your trade and then adjust the volatility number up and down to observe the theoretical effects. For example, see how your trade would perform if IV was crushed to 50 or 80 instead of 124. I talked a lot about this to someone else, Kanu Bhatia. You can check it out here to learn more. Like I already said, using the tools of the TradeKingdom may help you do your homework, but you still have to decide whether or not to ante up your dough to do the trade." She returned the carrot gadget to Snowman.
Anyway and Snowman thanked the pixie for her help. Before she turned to vanish they asked, "What's your name?"
The pixie quipped, "I don't really have a name. Some call me ‘Niki Trades.'" She winked once more and she was gone, just as quickly as she had appeared.
And so it came to be, Pixie Niki traveled the land to help traders right their wrongs, wielding her powers from her magical TradeKing Elvis shades. The traders don't necessarily live happily ever after, but hopefully they are a little more wiser for the wear, including Niki herself. Stay tuned for more trading stories from the TradeKingdom.
THE END.
For a list of previous All-Star Trades, please click here.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
The tools utilized above are not intended to be a substitute for your own judgment. You are solely responsible for evaluating the merits and risks associated with the use of investment tools before making any investment decisions. TradeKing is not responsible for any losses that occur from such investment decisions.
Lawrence G. McMillan has a professional business relationship with TradeKing.
Black night by Lamanda2 on Flickr
Tinkerbell by Barry Wallis on Flickr
