Thursday, October 06, 2005

Trade Dissection: ECA Synthetic Straddle

One of the advantages of options trading is that as a trade progresses, one type of risk can be traded for another. Buying stock is kind of a crapshoot. You make a guess and you hope you're correct. Once your in the position there isn't much you can do to change your odds, aside from closing part or all of the position out. For example if you buy stock for 50 bucks and it goes up a dollar, without using options the only way to close the position out is to sell some of the stock. If you sell all of your stock though, you can't profit from further movement. Alternatively, you could sell half your shares instead. This gives you the opportunity to profit from further upward movement, but substantial capital is still at risk. There is no good way to fine-tune these adjustments with just the underlying issue. Since options have a non-linear profit graph, they provide the power to fine-tune the nature and type of risk that the trader is exposed to.

Here's an example of what I mean by trading one type of risk for another. Yesterday in about the last hour trading, I was looking at Encana (Symbol:ECA). ECA had allready fallen over 3 bucks that day. This was on top oflarge losses the day before as well. Cramer had written an article on basically stating that he though companies with natural gas exposure like ECA would have good earnings and their stocks would go up on those earnings. (I don't think he was saying to buy at that instant though.) The entire energy sector was imploding, and ECA was down almost 10 % in 2 days. This was not the time to play countertrend. I was not interested in entering any bullish positions in ECA at that point in time but I was interesting in positioning myself for the earnings report.

Going long or short is kind of a crapshoot. In a volatile time like this, I would prefer to get into a position where I can benefit from large volatility whether or not the stock goes up or down. I didn't know where ECA would be in a month, but I was reasonably confident that in a month, it would make a big move away from the current price it was trading at, which was 54ish. The easiest way to construct a position that can benefit from a big move when you don't really know which way the move will be is to buy a straddle. The problem is, I was not the only one who thought ECA could make a big move. Everone thinks this, and the price of the at the money (ATM) November straddle reflected this. It would cost well over 7 bucks per straddle. This means ECA would have to move over 7 bucks for me to merely break even. The stock had almost moved that much in 2 days allready, so it might not have been that bad of a bet to make. (I will explain later why I wanted November instead of October.)

I wanted to get into the straddle at a better price though. My plan was to leg into a synthetic straddle. To build a synthetic straddle, one buys/shorts stock and also buys 2 puts/calls for every share of stock bought/shorted. In order to get a better price than 7 bucks or so for the straddle, my plan was to leg into the straddle.

This is what I mean by "legging into a trade". A straddle is a combination between a bullish and bearish position (like most option strategies). In my case the bearish position would be shorting a share of stock, and the bullish position would be buying 2 calls for each share of stock shorted. One can reduce the price of the over all straddle by entering the bullish position at a lower price than when you enter the bearish position. The idea is to speculate on the short-term movement of the stock in an outright directional trade. By speculating correctly, the profits can be used to reduce the cost of the eventual neutral position.

Why did I choose to use the synthetic straddle(short stock + 2 calls) instead of the regular straddle (put + call)? I had recently read this article on the Daily Options Report Blog about shorting stock and buying calls on a ratio. He says he gets better executions this way, so I just wanted to give it a try.

Yesterday, the entire energy sector was selling off in a panic. ECA had dropped quite a bit. I didn't think that ECA (or the energy sector in general) was done selling off, so even though I felt like I was late to the party I decided to sell ECA stock short in the last hour of trading. I waited for ECA to uptick about 10 cents and then put in my short order. I was executed, and the stock dropped another 40 cents or so from my execution by the end of the day, so the trade was off to a good start.

Selling the stock short was the first leg of my straddle. I was taking on a lot of upside directional risk for hopefully a short period of time. Hopefully by being early enough into the sell-off, the upside risk would be small, but there was no real way to know at that time if I was early enough into the sell-off (a sell-off that had been going on for 2 days). It turns out that this time, shorting the stock worked. This mornign when I woke up, ECA was down over 3 bucks on the day.

Now I had 3.74 profit on my ECA short. The November 50 calls were selling for 3.70 bid and 3.80 offered, so my profits from the ECA short were just about enough to pay for about half of the spread, since I need to buy 2 calls for every share shorted. Afterwards I glanced at the puts and they were 3.30 bidand 3.50 offered, so I definately was getting a better execution buying the calls then I would have obtained buying the call and the put. I saved myself 10 cents extra by not having to pay that 20 cent spread in the put. (The spread in ECA shares themselves the day before would have been like a penny or 2.) By legging into the trade, and using the synthetic straddle instead of the regular straddle, I purchased the straddle for 3.86 when the market offer price was 7.30. This puts me into the straddle for about half of what the risk would otherwise now be at that point, but I had to take all of that upward directional risk to get to this point.

Making 3.74 over night was just about ideal. This turned out better than I had hoped. At that point I could have just covered my short and taken the 3.74 profit and I would have been quite happy to do so. I wanted to do better than the 3.74 though, and that is why I changed the position into the straddle. The profit gave me the opportunity to stay in the game, but change my odds going forward by building a better trade than what I started out with.

This is how the trade looks now. At the moment I am completely delta hedged. That means that I have no risk of losing money do to changes in the stock price. In the near term I have locked in most of that 3.74 profit from the short sale by turning the position delta-neutral. This is what I meant earlier by trading one risk for another. I have traded my delta risk for theta risk and vega risk. Since I am negative theta and long gamma, this means that I will lose money slowly every day. I need the stock to move enough to overcome this time-decay. Assuming, I hold the position until expiration I need the stock tomove at least 3.74 between now and then to overcome my theta and any potential vega losses. If I had not legged into the trade I would need a movement of 7.30 instead.

Vega risk is my exposure to changes in the implied volatility. Volatility in ECA is high and my straddle will be worth less money if implied volatility lowers. With earnings aproaching, I doubt that there will be much IV loss any time soon. I also make money if IV goes up, but most likely the bulk of any gains will come from actual stock market movement. If there is an IV increase between now and when I sell the calls this most likely be small bonus. It is unlikely that IV will increase enough in these calls to create profits significant compared to those that could be obtained from actual stock movement.

Here is my plan going forward. If the profits from the short stock part of the straddle exceed the cost of the calls in a short period of time, I will probably look to cover the short stock. If that happens, going forward the trade would be completely risk free, as I would be sitting on a free call option. The plan at that point would then be to hold the call into ECA's earnings which are on Oct 26th I think.

This is why I chose to buy the Nov. Call, instead of the Oct. call. I wanted the ability to hold through earnings. The Oct. call expires 5 days prior to earnings. However, I won't necessarily hold through earnings. I just wanted the option to do so if I need to. If there has been a lot of apreciation in the stock prior to the earnings, and if I have a profit I will consider closing the position out just before earnings. After the earnings come out there is danger of a volatility implosion (remember my Vega risk) since uncertainty will be removed from the market.

With a little luck in my timing, I might capture downside profits as the energy sector continues to sell off, and then make money on the way up if ECA recovers into earnings.


At 8:06 PM, Blogger Seneca60BC said...

interesting read! especially for a newbie in the options world.



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