10 minute read
Tactics
from December 2019
BASIC
News-Driven Trading
Basing trades on public announcements and earnings reports can generate profits without a major investment of time
By Michael Gough
Investors always have something to trade, thanks to a six-and-a-halfhour equity trading day, extended hours for futures and weekend crypto markets. But not everybody has time to trade. It’s impossible to stay glued to the screen because other areas of life demand attention, and staying awake through the night hardly seems feasible. So, given a limited schedule, is there a more effective way to trade?
For busy investors, news-based trading provides a way to stay engaged with the markets. It’s exactly what it sounds like—buying and selling around a particular public event. Each month, dozens of market-moving announcements, such as Non-Farm Payroll reports, World Agricultural Supply and Demand Estimates, and Federal Reserve policy meetings, are released to the public. All of them present scalping opportunity. Besides those announcements, the hundreds of earnings reports released quarterly provide a nearly endless stream of short-term trading opportunities. Consider earnings announcements. Each quarter, before a company releases its financial information, dozens of analysts make an educated guess on how the company performed. The difference between what they expect and what actually occurs can shake the stock price or not move it at all. It’s these guesses and expectations of movement that provide a great short-term opportunity for the savvy options trader.
Pro traders anticipate events that may result in market-shifting news.
Using options markets, traders can gauge how much market participants are expecting the underlying to move after the earnings release. This number is reflected in the implied volatility of the options expiring closest to the earnings date. Selling options around those price levels can be a profitable one-day trade if the stock moves less than expected.
Consider the example of a recent Apple (AAPL) earnings report. An earnings calendar shows Apple was releasing earnings on Wednesday, Oct. 30, after the market close. Using the implied volatility of the options expiring closest to the earnings release, Friday, Nov. 1, the market was expecting a move of +/- $12. With Apple trading around $243 on Oct. 30, the market was expecting it to stay within $255 and $231 before the options expired on Nov. 1. Using those ranges as a guide, a trader could sell premium around these prices to bet on an inside move.
An iron condor provides an ideal strategy for earnings plays because of its defined risk, lack of directional bias and low capital requirement. Given the expected move of +/- $12, a trader could sell the 225/220 and 260/265 iron condor for $0.76 at the close on Wednesday. The short options were placed beyond the expected move just in case Apple moved more than +/- $12. After the market closed, Apple released its financial performance and the next day opened higher at $247.24, a move of $4 relative to the expected +/- $12. With the price of Apple well within the iron condor’s short options, the trader could have bought back the spread for $0.03, a nice profit of $0.73 in less than 24 hours. Traders can apply that strategy to countless earnings announcements if the underlying has heightened implied volatility and a liquid options market. Consider the recent release of Goldman Sachs (GS) earnings. Goldman Sachs released its earn ings on Oct. 15 before the market open with the market expecting a +/- $7.50 move. Given Goldman Sachs’ closing price of $205.82, the 195/190 and 215/220 could have been sold beyond the expected move for $0.74 on Oct. 14. The next day, after the earnings release, traders could have bought back the iron condor for $0.13 because Goldman Sachs moved less than the market expected, a $0.61 profit in less than one day.
The key to these short-term earnings trades is finding underlyings with overpriced options. As the earnings date approaches, uncertainty increases, which pumps up the price of options. After the release, there’s no longer uncertainty because the earnings become public, and the option prices deflate like a balloon. This balloon release can be seen in the reduction in implied volatility; Apple’s implied volatility decreased from 76 to 28 while Goldman Sachs’ implied volatility decreased from 41 to 28.
In the search for short-term trading opportunities, consider earnings announcements and other public events with defined risk strate gies. Earnings releases can provide consistent trading opportunity because the trades are short-term, the profit potential is high and the date of announcement is known ahead of time, removing the need to incessantly check price quotes.
Michael Gough works in business and product development at the Small Exchange, building index-based futures and professional partnerships.@small_exchange
INTERMEDIATE
(Covered) Call to Action
Savvy investors can turn a 401(k) or IRA into a facsimile of a covered call
By Anton Kulikov
Americans store a big chunk of their investments in 401(k) plans or IRAs for two reasons. First, employer matching funds can add up. Second, partic ipants can’t easily withdraw cash to buy an iPhone or a take a tour of Europe. As a result, retirement accounts can build a lot of value over time.
But the sponsors of most plans limit participants’ choices to nothing more than passive mutual or index funds. It’s time to change that. Using the right fund in a 401(k), combined with another simple strategy, can boost returns in normal market conditions and cushion against downturns if the market drops. Let’s see how.
In a normal trading (margin) account, investors can use options to hedge/amplify returns on long stocks—exchange-traded funds (ETFs), for example. But they can’t do that in a 401(k)… or can they? In today’s world of advancing financial technology that’s geared for individual investors, some brokerages allow customers to have a 401(k) or other retirement account and sell calls in them without owning stock. That means that investors can take advantage of the same strategies that a normal trading account would, but with a little more work.
By having a 401(k) invested in an S&P 500 Index fund (which most plan providers have in one form or another), participants can open an IRA account at another broker that allows selling naked S&P 500 calls. Then all they have to do is contribute or transfer enough money to the IRA to meet the buying power requirements the broker mandates for selling naked calls. The result is that they have two retirement accounts—one where their S&P 500 fund resides (the 401(k)) and the other where the short S&P 500 calls reside (the IRA). The net performance and tax implications will be exactly the same as if they were selling covered calls against their long S&P 500 fund in the 401(k).
Now, one question remains: How does an investor know how many calls to sell in the correct proportion to the fund in the 401(k)? Simply take the dollar amount invested in the S&P 500 mutual fund in the 401(k) (the brand doesn’t matter, they all have the same exposure to the index), divide by the price of SPY (the ETF that tracks the S&P 500 and has very liquid options) and then divide again by 100. For example: If an investor places $300,000 in an S&P 500 fund in a 401(k), then divide $300,000 by $300 (the price of one share of SPY), and then divide by 100. The answer in this case is 30 SPY calls. So, selling 30 SPY calls would create an S&P 500 fund covered call between the positions in the 401(k) and IRA account.
Now there's one more caveat. Because the mutual fund and the calls are held in different accounts, and investors technically can’t close the fund position in the 401(k) without tax consequences, they have to make sure the calls in the IRA are rolled near the end of each expiration cycle or that they are in the money. That way, they avoid any assignment risk in the IRA that would require depositing more money in the IRA, which might not be possible.
The benefit is that investors get the full performance of a covered call strategy when they add the two accounts’ P/Ls together. A drawback is that selling calls in an IRA is capital intensive, meaning the amount of money required in the IRA is much larger than if one were conducting this strategy in a regular trading account. However, investors who have the capital and a willingness to monitor positions at least once a week can enjoy the benefits of a covered call, plus the tax benefits of a 401(k)/IRA.
Anton Kulikov is a trader, data scientist and research analyst at tastytrade. @antonkulikov
ADVANCED
Zeroing Out Those Utility Bills
With this hack, investors can make utility companies pay the family gas and electric tabs
By Michael Rechenthin, Ph.D.
Traders consider utility stocks relatively safe investments—partly because regulation limits competition. Besides, the massive infrastructure required to produce gas or electricity is so expensive that it serves as another nearly insurmountable barrier to entry.
What’s more, revenues tend to remain consistent for utilities because consumers generally use about the same amount of power every year. With a stable income stream, utilities often pay higher-than-average dividends. Take a look at the dividend yield of the utilities in The best bet (right). An investor could use them to offset household gas and electric bills. But how many shares would it take to cancel out a hypothetical $100 utility expense? Well, consider the utility Dominion Energy (D). The quarterly dividend is $0.91 and, unsurprisingly, investors expect to receive it four times a year. To cover a $100 utility bill, an investor would need the dividends from 330 shares. Multiplying 330 shares by the share price of $81.33 means an investor would have to own nearly $27,000 worth of stock.
But options provide more opportunity while requiring less cash.
Here’s how: Instead of purchasing 330 shares, one could buy 200 shares and sell 85 calls against the stock held. That offers the advantage of still receiving the $0.91 per share quarterly dividend while also making money from the sale of the call.
Assume an investor would receive $0.50 per share by selling the November call, which is 51 days from expiration, while still receiving $0.91 for the dividend for each of the 200 shares held.
Instead of needing $27,000, the investor could use options and use one-third less and receive 20% more ($120 versus $100 per month).
Michael Rechenthin, Ph.D., (aka “Dr. Data”) heads research and data science at tastytrade.
CHEAT SHEET
A Covered Call for Any Bias
Maximize profits and reduce risk with covered calls. Your choice of strategy depends upon your directional bias.
By Michael Rechenthin, PhD
Options can be visualized with risk graphics—in fact, all trading platforms have them. The chart here shows the payoffs associated with holding 100 shares of stock at a price of 100 and selling the 95 call (neutral to slightly bearish bias), the 100 call (neutral to rangebound bias), or 105 call (slightly bullish bias).
Neutral to slightly bearish bias
Slightly bearish on the stock? Consider closing the 100 shares, or selling short. Or sell a covered call slightly in-the-money against the shares held. That will lower the breakeven considerably and protect against a decline of up 10% in the value of the stock.
Neutral to range-bound bias
With a neutral to range-bound belief in the stock, Sell closer to an at-themoney call. That will yield the greatest value for the covered call and protect against a 3% to 10% decline in the stock price.
Slightly bullish bias
Slightly bullish on the stock? Make more money on the upside move. Place the call farther out of the money. For example, sell 1-5 points above the market. The profit on the call (covered) will still offset up to a few percent of a downward move.
Very bullish bias
More bullish? Then place the strike farther out-of-themoney. But that will deliver less premium and less protection if the stock declines. The farther out-ofthe-money the call, the lower the probability of success, but there’s more profit potential if the stock rises dramatically.
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