Lawrence McMillan and Nicole Wachs team up on InstantGain's trade.
This All-Star Commentary post features two Trade Notes (long leg exit, short leg exit) from InstantGain. Thanks for helping us talk about a new strategy, InstantGain!
"Got hammered. Earnings went the wrong way. Did not go the way I thought. - Call Ratio Backspread exit from InstantGain
InstantGain,
Wow a new trade! How exciting! The Call Ratio Backspread is not included in the The Options Playbook. Fear not! I will be happy to guide you in the meantime. How so, you ask? In the Rookie's Corner, of course!
ROOKIE'S CORNER
ORCL = 19.37 as of close 3/28/08
3/26 2:35 pm Trade 1: Sold to open 5 ORCL April 17 calls @ 3.94
3/26 2:35 pm Trade 2: Bought to open 10 ORCL April 20 calls @ 1.52
ORCL = 20.94 as of 3/26 close
Call Ratio Backspread - not in The Options Playbook
Selling one call gives you the obligation to sell stock at Strike Price A if the option is assigned.
Buying the two calls gives you the right to buy stock at Strike Price B.
This play enables you to purchase two calls that are at-the-money or slightly out-of-the-money while potentially putting a few bucks in your account (but don't go shopping just yet, that money will need to stay put for now.) The goal is to obtain the calls with Strike B for a credit by selling an in-the-money call at Strike A.
This position is similar to Play 9 The Long Straddle because you have the ability to make money if the stock moves in either direction. The difference is the play is mostly bullish since there is a much smaller benefit on the downside. This play has unlimited upside potential, so ideally you want the stock to go on a tear, surpassing Strike B considerably. If you are completely wrong on the direction, and the stock falls sharply, you may escape a near disaster with the credit you collected at the start of the position. Unlike Play 17 Ratio Vertical Spread with Calls, the call you are short is covered, as you own more calls overall than you sold.
If you establish this play without the net credit, you will miss out on half of its strategic benefits. That would be similar to leaving your life jacket at home. The credit on the downside is like an emergency rescue. Not the situation that you would have hoped for, but it beats the alternative and you will gladly take it since things did not work out as planned.
It would be best to establish this play with the strikes being as close together as possible, as that will narrow the nasty abyss between them. Looking down into it is like peering off a high cliff. It will motivate you to steer clear and is terribly dangerous if you slip and fall. The pain point of this play is the bottom of the abyss. That is the long strike of the two calls you purchased. Which ever way the stock decides to go, you want it to be fast and furious, as time decay is working against you. You would prefer the stock to move significantly higher, but drastically lower would earn you a small amount of cash too.
Because you can make money if the stock moves greatly to either side, some investors may wish to run this play around an expected earnings or news event.
The maximum value of a call backspread on the downside (the credit you get for missing the mark entirely) is usually achieved when it's close to expiration. You may wish to consider running this play shorter-term, e.g. 30-45 days from expiration.
BREAK-EVEN AT EXPIRATION
When established for a net credit there are two break-even points:
Lower breakeven: Strike A plus net credit received when position is established.
(17 + 0.90 = 17.90)
Upper breakeven: Add to Strike B: the difference between Strike B and Strike A, minus the net credit received.
(20 - 17 = 3 - 0.90 = 2.10; 20 + 2.10 = 22.10)
Note: If a different ratio is used, only the upper breakeven point (22.10) will be affected. Calculate it the same way, except the result (2.10) will be divided by the net long calls in the trade. In this case, you are long two calls and short one call, for a net long position of one call. (2.10 / 1 = 2.10; 2.10 + 20 = 22.10)
THE SWEET SPOT
You want the stock to go to the roof. If that's not possible, going in the tank will yield a small gain too.
MAXIMUM POTENTIAL PROFIT
Potential profit is theoretically unlimited if the stock goes up. If the stock goes down, potential profit is limited to the net credit received.
MAXIMUM POTENTIAL LOSS
Risk is limited to the difference between Strike B and Strike A, minus the net credit received. This occurs if the stock lingers at Strike B as expiration approaches. (20 - 17 = 3 - 0.90 = 2.10)
MARGIN REQUIREMENT
Usually equal to the difference between Strike B and Strike A, minus the net credit received.
(20 - 17 = 3 - 0.90 = 2.10)
AS TIME GOES BY
For this play, time decay is your enemy. It's eroding the value of the option you sold (good). However, that will be outweighed by the decrease in value of the two options you bought (bad).
IMPLIED VOLATILITY
After the play is established, increasing implied volatility is somewhat positive. The value of the option you sold will increase (bad). However, that will be outweighed by the increase in value of the two options you bought (good).
Whew! Well that's all for me. Mr. McMillan, take it away...
TRADE DISCUSSION and RESEARCH
This is a typical call backspread. A backspread has a profit graph that looks like a straddle, with the left side cut off. Typically, backspreads are established for a credit, so that if the stock falls sharply, the spreader will earn at least the credit of the spread. Conversely, if the stock rises dramatically, the additional long calls in the spread will provide unlimited upside profit potential.
This spread was established for a credit of 90 cents per spread (3.94 - 2 x 1.52 = 0.90). Figure 1 shows the profit potential for this position (the straight, black lines show the profit potential at April expiration; the colored lines show the potential at the dates shown in the same color in the inserted box on the upper left of the graph). As you can see, ORCL must rise above 22.10 or fall below 17.90 in order for the position to be profitable at April expiration. The worst result would occur (a loss of 2.10) if the stock were exactly at 20 at expiration. I'm not sure exactly where the stock was when the spread was established during the day on March 26th, but by the close, the stock was at 20.94 -- much nearer the upside breakeven point than the downside one.
Click here for a larger image.
Since the position is similar to a long straddle, one wants the same thing that a straddle buyer does - a stock movement that is great enough to exceed one or the other of the breakeven points (17.90 and 22.10 in this case). Sometimes one relies upon normal stock volatility to produce such a move, but in this case, the buyer is setting this up because ORCL earnings were expected to be announced after the close on March 26th - the day the position was established.
An earnings announcement can sometimes be a good reason for the stock to move, but ORCL hasn't moved too much in the past on earnings - really, only one 2-point move back in September '06. You can check how stocks have moved on past earnings reports by looking at the historical data on the web site: http://www.whispernumber.com/ (I'm not a big fan of the whisper numbers themselves, but the statistical data on this site is good).
You can gauge how far the option market expects the stock to move by looking at the price of the near-term straddle. In this case, on the close of March 26th, the April 20 straddle was offered at 2.15. This backspread had approximately the same parameters as the straddle - requiring move of a little more than two points, either above or below 20, to break even.
So, this spread was set up rather bullishly going into the earnings. I also know that certain traders on CNBC were touting the fact that call buyers were heavy in the stock prior to the earnings, so they were predicting a positive earnings report from ORCL. Normally, we advise our clients not to pay attention to heavy call or put volume on the day of, or the day before earnings are to be reported. Volume that close to the earnings is usually merely a lot of public speculation and doesn't correlate well at all with the eventual earnings move.
In this case, ORCL reported earnings right in line (30 cents, which was exactly the "Street" consensus). Also, revenues were right in line, and so was guidance for the 4th Quarter. This was not what the speculators wanted to hear, and the stock fell 9.1%, to 19.07, in after-hours trading on the 26th. It opened a little higher than that the next morning on NASDAQ, but stayed within a range between 19.25 and 19.86 for the next two days.
As you might imagine, this caused a loss in the spread - along the purple lines on the graph in Figure 1. As of Friday's close, the spread could be removed for a debit of 1.80, or a loss of 90 cents ($90) per spread.
In my opinion, this position was going to have difficulty making money. The profit range was just too wide for the historical range of ORCL movements on its earnings reports. Sure, it could have had a move larger than anything in the past, but that would be fighting the odds.
Each quarter, we play a number of earnings moves in our publication, The Daily Strategist. However, we are very selective about the ones we buy. In general, a call backspread or a long straddle is a reasonable way to "play" an earnings report, but we want to ensure that the stock has often made moves of the required size in the past. Furthermore, we want to see that the stock has followed through on earnings gap moves in the past (i.e., if the stock has gapped down in the past - on earnings - has it then rallied back, or continued to fall?). If both of these criteria are met, and they are usually not, then we might entertain a straddle purchase or backspread.
One last point: I would generally select a straddle buy over a backspread when trying to play an earnings report, unless the breakeven points were significantly better with the backspread (normally, they're not). The reason I say this is that, if you can get either one for the same breakeven points, then you might as well buy the straddle because you have all that extra downside profit potential if the stock gets smoked on an earnings report.
This comment and any market data included here were prepared on 3/31/08.
President
Thanks again InstantGain. I am sure the Community is psyched to have a shiny new topic to discuss and maybe even try out! Better luck to you in your future trades. No one likes when things don't work out, but through your Trade Notes, you may have helped other TradeKingers from succumbing to a similar fate.
TradeKing Staff
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.
Lawrence G. McMillan has a professional business relationship with TradeKing.
