Post-Mortem on a BBY Covered Combo

BBY Daily 270814

 

Hello, Friends. It’s helpful to go back over trades from time to time. Reviewing winners is normally pleasant, but I find that I learn more from the ones that got away. The trade that I would like to discuss today was an odd hybrid; a trade that produced a small profit despite some poor trading on my part. I’ve been a student of Todd’s since the spring of 2009, and I think that I have a pretty good understanding of his approach to chart analysis and trading. Psychology and noise can still get in the way from time to time, even when we (okay, I) know what to do.

Every day, I run a scan that’s designed to identify options with prices that are high relative to where they usually trade. That’s based on their implied volatility; the ThinkorSwim platform on which I do my options trading does a great job of providing analytic tools and scans. On August 19, the symbol BBY came back; the scan noted that the September monthly options were priced to yield implied volatility of around 50 percent, in the 69th percentile of its range for the previous year.

As you’re probably aware, volatility in general has been quite low in recent months. In BBY’s case, the implied vols for September were elevated because earnings were due out prior to the opening on August 26. Despite the looming report, I was intrigued; it’s way more fun to sell options with high relative and absolute volatility rankings, and this qualified in both respects. The daily chart was interesting. Following a long decline that lasted until the end of January, 2014, the stock had been trading sideways to up, and since hitting 32.24 on July 3, it had dropped back to as far as 28.85 on August 15. That put it between the 38.2% and 50% retracement levels, and also coincided with the moving averages, which often provide support, particularly in conjunction with those Fibonacci levels.

The stock, by the time I looked at it, had moved higher, and was trading around 30.50. To take advantage of the relatively elevated option premiums, I decided to put on a covered combo, which is sometimes called a covered strangle. This consists of a long stock position, a short call and a short put. Two option premiums are collected, which is nice; the risk is that a rapid decline in the stock will result in being put at an unfavorable level. Nonetheless, in a generally uptrending market, with a rebounding stock, this trade seemed a fair bet. I bought BBY stock at 30.47, and sold September 32 calls for 0.87, and September 28 puts for 0.72.  Based on option pricing, ThinkorSwim calculated that the September 32 calls that I sold had a 67.5% chance of expiring out of the money, while the 28 puts that I also sold had a 69.45% chance of going out worthless. In these trades, being called away is a good result, as is having both options expire worthless. The outcome that has to be guarded against is a move through the strike price of the short put.

Yesterday, the earnings did come out, with weak forward guidance from the company’s executives. The stock opened up down 2 percent and more or less kept going, reaching an intraday low of 29.76 before closing at 29.80, a decline of 6.8%. I didn’t stick around long enough to take in all of the show, exiting with the stock at 30.38. Because of a steep drop in implied volatility (which reduces the value of both puts and calls) following the earnings release, and the benefit of a week’s worth of time decay (Theta) I was able to buy back the short options at levels that enabled me to eke out a small profit on the overall position.

While I wasn’t thrilled with this outcome, I avoided a loss. So why do I feel that I traded it poorly? Because there was no compelling reason to exit. Even at the low yesterday, the stock didn’t even reach the 38.2 percent retracement level; the uptrend remained intact. My concern over the rapid drop wasn’t unwarranted, but the price action as reflected in the chart didn’t really justify liquidating the position. I used my imagination, and my experience, which suggested that a decline of that magnitude would probably continue for a while, rather than setting up a contingency plan based on price action, and reacting appropriately. I read some reports that painted a pretty dire picture of BBY’s fundamentals, and that no doubt had an impact on my trading. They say that old dogs can’t learn new tricks (which may be incorrect), but old dogs can, apparently, keep making the same mistakes from time to time.

As it turned out, the company today (Wednesday) reiterated its dividend payment, it received some support from the analyst at Morgan Stanley, and bargain buyers jumped in, leading to a close at 31.69, a 6.3% rise. My stock, of course, would have been worth 1.59 more per share; the calls that I bought back yesterday became more expensive, but that was partly offset by a drop in the price of the puts. In short, the chart looks much healthier now, and while I still don’t own a crystal ball, and the stock may just turn south on Thursday morning, I’d be happier if I had continued to hold it. More importantly, I would have been observing my trading discipline, rather than letting emotions win out. Lesson (re)learned.

Just a note as to Thursday; it will, in effect, be Friday for this week, since no senior market participant who can help it is going to be in the office on Friday. The e-mailed reports of absence will go out late Thursday afternoon; while they’ll all say “reachable by cell in case of need” the junior traders left on the desk know that they had better not need to make that call. It’s late enough in the year that negative impressions can have an impact come bonus time; better to be cautious. Volumes should be thin, and while that can lead to exaggerated moves in response to, say, a surprising headline, possibly creating opportunities, it’s pretty tough to forecast direction. Most professionals in the market are vaguely aware that equity indices are close to highs, and bond prices likewise. Under the circumstances, since it’s still a dangerous world, some lightening up of positions, or placing of hedges, might seem prudent prior to loading up the SUV for the trek to the Hamptons/Cape/Vermont. They’re all pretty nice this time of year.

Here’s hoping that your trading day and weekend will be safe, and pleasant.

 

About the Author kevin

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