OPX Option Strategy

This is the second article in Fujisan’s ongoing series on option spread strategies:

I hope everybody is having a wonderful Easter holiday and get ready for our favorite week — OPX week!

I know many equity traders including Mole absolutely hate OPX week, but this is what spread traders like me live for.  This is our bread and butter, the ultimate purpose of our existence, the payoff of the month….. well you got my point.

Many of you know that option time decay accelerates exponentially toward OPX.  If you are an option buyer, you would absolutely hate it, but if you are a seller, this is the most exciting time of the month, and there are many ways to take advantage of time decay, and here is how you play it out.

1.  Pick the underlying stocks that you like to play options with

Towards OPX, OTM options becomes extremely cheap (no time premium left) although ATM/ITM options still have [intrinsic] value. As a spread trader, this particular feature becomes very attractive to take a speculative position. As both Mole and ErikD pointed out, XLF may be topping out and ready for a retracement — or maybe some bank stocks which had been  benefited from this huge rally may like to take a break.

2. Look for a spread combination where you can find at least 1 to 3 risk/reward ratio

Once you decide which vehicle you like to play with, then you  look for a spread combination where you can find at least 1 to 3 risk/reward ratio.  You buy a cheap OTM options to sell ATM/ITM options (this is a credit spread).  If you are selling ITM options, it should be within one standard deviation.

I didn’t quite come up with 1 to 3 risk/reward ratio on this one, but I’m pretty sure that this may fulfill my requirement on Monday if it opens down.  With this spread combination, you put in $0.69 cents to make $1.31, which is not quite 1 to 3 R/R that I’m looking for…..yet.

3. Take a profit!

You know how vicious OPX weeks can turn out to be.  It goes up and down big time and many traders get whipsawed through the whole week ended up making no money.  If you put this credit spread on, and once the market started going your way, please take a profit once you make more than 20%.  You don’t need to realize the whole 300% return on this trade.  If you like to go all the way, don’t forget to take some off the table so that you are only playing with house money.

4. Do not play more than 1~5% of your total capital

This falls into “speculation” category (I know you are all speculators but I’m not) and please do not put in more than 1~5% of your total capital into this trade.  This is just an OPX play and you don’t want to lose any sleep over this.

BONUS TOPIC:  GOOG Earnings

As I promised last week and some people have already asked me how I play with GOOG earnings, and here is how.

GOOG is known to have earnings right before OPX and this plays out perfectly for OTM (Out of The Money) Butterfly to take advantage of high IV (this strategy technically lets you sell IV) and time decay.

Butterfly is a combination of 2 spreads – one credit and one debit spread with the same higher strike price (There are more variation to it and I’m hoping to cover this topic very soon).

1. Determine the price movement from past earnings results

Now, let’s look at GOOG’s past performance after earnings:

On average, GOOG had a price movement of 7% after earnings (I did not include Q4 results as Q4 earnings come out after OPX).

2. Determine the price movement by Straddle/Strangle combination

Instead of going through the trouble of calculating the previous earnings results, here is the easiest way to determine what is already priced in the market.

You take ATM straddle and strangle, take the costs of the spreads and calculate the average price.  This is the expected price movement of GOOG.

As you can see, ATM straddle is $29.55 and strangle is $40.65, and the average cost is $35.1.  This means that the market expects GOOG to move $35 (9.5%) in either direction by OPX.

(Please do this exercise right before Thurs close in order to estimate the market’s expected move)

2. Determine the Strike Price

Now, GOOG is also known for having expired in 50 point increments during OPX (i.e., 300, 350, 400, etc.).  Mole here: that’s what’s referred to as ‘pin risk’. Here is a look of the past year’s GOOG’s OPX closing price.

Now, let’s say that today is Thursday right before earnings.  We have already gone through the above exercise to come up with  market expectation.  We also know that GOOG is going to expire somewhere in 50 increments.  Now it’s up to us to decide which strike price to pick:

a) Slightly bullish or slightly bearish

In this scenario, we expect GOOG to move within the range – which is $35 up or down.  Here is how it looks like:

You can pick 380/400/420 butterfly if you are bullish, or 330/350/370 if you are bearish, or maybe both.  In either case, the cost of this position is pretty cheap and risk/reward ratio is very nice.

b) Looking for a surprise

Just like it happened to RIMM and BBBY, you are expecting a surprise earnings result from GOOG.  You like to go for a homerun!  It’s your pick.  You can buy OTM butterfly with any combination that you think it would be hit.  I am just showing two examples of OTM butterfly – one with 430/450/470 and the other with 280/300/320.  The costs of these butterflies are less than $1 per piece and the risk/reward is humongous.  But remember, the probabilities are against you and the price movements outside of one standard deviation would happen only 3 out of 10 times.

c) Combination

Or maybe you might like to make a combination of two spreads – one within the range and the other out of the range.  After all, these are very cheap spreads and you should be able to afford a couple of spreads like this without losing a sleep.

PS — This particular strategy could be used not only for GOOG but any other stocks with Thurs earnings release.  If you find a good trade, please share it with us.

I hope you enjoyed my posting this week.  I was very encouraged by positive feedback from last week.

If you have any requests for specific topics, or spreads that you like me to cover, please let me know.

Happy Easter, everyone.

Fujisan