Dodging the Bullet
Options expiration Friday can be a hectic day for options trading. Almost every options trader considers some management techniques. Do you close your credit spread for a ten-cent liquidation value in the morning, or do you wait until the afternoon to wrangle an extra nickel out of the position, risking a change in the underlying stock price?
Do you close your covered call position and roll to the next month now, or do you wait to see if it expires and trade on Monday?
Naturally, expiration Friday is one of the heaviest options trading days. Conservative investors are managing their positions and aggressive options investors are selling Naked Puts or Naked Calls for large profits in short order.
Trading Lessons: KCI – Kinetic Concepts Inc.
Setup
The July call options and put options for KCI had extremely high Implied Volatility (IV) greatly inflating their respective bid prices. Implied Volatility is commonly referred to as the “risk factor” when trading stock options. As Implied Volatility increases, so does the risk.
At market open, KCI was trading around $45.00. The 35 July put was trading for $1.00. That’s right, the 35 put, 22% out-of-the-money, was trading for $1.00. The option’s implied volatility was around 4.08 (408%).
To give you an idea how large that value is, the current average Implied Volatility for all calls and puts for the month of August is only 0.60 (60%)
Lesson 1:
If an option return looks to good to be true – it probably is. The naked returns on high implied volatility options looked great, but there is usually a price to be paid when you trade for high returns. Your money will be at higher risk. As soon as you see these high returns, do more research, make sure you understand why the market has priced the option this way. Once you know the situation, you can trade in a way that fits your risk profile and lets you sleep at night.
Risk vs. Reward
Trading the July 35 put for KCI would have given an investor a 2.8% Naked Yield for a one day trade. The put option was 22% out-of-the-money, so the stock would have had to drop about 10 points before the trade was at risk. Seems to good to be true – doesn’t it?
More to the Story
KCI is currently in the midst of a patent lawsuit with a competitor. Rumor around the market is that the verdict was to be released today, coinciding with July options expiration.
According to Merrill Lynch analyst Katherine A. Martinelli, a favorable verdict could help the stock rebound to the $60 range, but a negative verdict might push the stock down into the $20 range.
Lesson 2:
Many option investors trade options around news events, earnings reports, and pending lawsuits with Long Straddle plays. A Long Straddle is when you buy the same number of call and put options at the same strike price. This trade is betting on a large swing in the underlying stock/index price. The direction of the move doesn’t matter since one of the options could be profitable with a large directional move.
Hind-sight is 20/20
The jury did not release a verdict today, the stock closed at $42.60 thus the 35 puts expired worthless. In this case, many short option investors dodged a potential bullet and earned a great return for a one-day trade. Coincidentally, the July 40 puts were selling around $1.90 at market open, and would have yielded a 4.8% Naked Yield for a one day trade.
So, who didn’t Dodge the Bullet?
If an investor traded a Long Straddle on KCI, at-the-money (45 strike price), it would have cost them. At market open, the 45 call was trading for $2.80 and the 25 put was trading for $2.90. The investor would have paid $5.70 to enter the Long Straddle.
Since the stock closed at $42.60, an investor could have sold to close the 45 put for about $2.40, incurring a loss of -58%.
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[tags]options trading, option investors, long straddle, covered call[/tags]