Using Ratio Spreads to trade earnings: A live-example on INFY

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uncletheta

Result season is a challenging time for short-term trading. You never know what’s gonna hit you, how, and you wonder whether you should even bother messing around with leverage at such times. But, for Uncle Theta, earnings is time to hunt. Here’s how:

1. Liquidity

This is the primary condition to trade stock options. While NIFTY is the most liquid options market in the world (you probably didn’t know that, did you?) our stock options don’t trade as much. Generally, we find higher liquidity in stock options close to results. At Capitalmind, we’ve built a tool to keep a track of the stocks with the highest liquidity in their options. It’s available on SNAP here: http://snap.capitalmind.in/#/liquidity

2. Implied Volatility (IV)

We’ve found implied volatility to be cyclical, more for some stocks than others. Generally, IVs peak out on results day, bottom out somewhere in the middle of two result announcements, and then go back up. Unless there’s some event-based news that drives up IVs from time to time. One stock that shows this classic behavior is INFY. Consider this chart:

Infy-1

The lower panel is the implied volatility. Got the idea? So we now know there is a good chance IVs are going to crash, and take option premiums down with them fairly quickly once results are declared. How do we take advantage of this? Well, one way is to write Strangles or Straddles. But today we want to talk about Ratio Spreads. But first, there’s one more thing…

3. Price Extremes

We’ve discussed mean reversion in IVs. What about mean reversion in price? This is why we like price extremes to initiate Ratio Spreads. The idea is to take a contrarian position. If the stock is near it’s 52-week low, with its IV near 52-week high, the position we like to construct is this:

(a) Benefit if there’s mean-reversion in price and the stock goes up
(b) Benefit if it goes sideways post-results and IVs collapse, and thus, option premiums
(c) Benefit if stock goes down to up to 5-10% post results, but not any further

4. The Ratio Spread

This spread, allows us to do exactly the above. A ratio spread is when you buy one call (or put) option and sell 2 (or more) call (or put) options of a further strike for a net credit. We only like to do these when our breakevens are 10-15% away (consider 1SD for reference) and the yield on a profitable trade is at least 2%.

5. Ratio Spread before INFY Results

Since INFY met all these conditions before its results, we did a trade on it on Oct 13. We sold 2 lots of Oct 960PE @ 12, and bought 1 lot of Oct 980PE @ 16.50, for a net credit of 7.5. INFY’s lot size is 500, and this position required about 1.33 Lakhs to put on. That’s a potential return of 2.81%. Here’s the payoff for the trade:

infy

Notice how the breakeven was close to 930. The spread would’ve made a max return of 10% had INFY expired at 960. And anywhere above 980, you still make the 2.81%. At the time we did the trade, INFY was trading at 1030. That means the breakeven was a good 10% below. If you’re more comfortable with charts, here’s how it looked (the stock hasn’t moved much since then):

INfy 2

The Result

Next day, the results came out. IVs collapsed. The stock was volatile but went up and stayed there for a while, giving us enough time to book out of the trade for 6.8 in profit. That’s Rs. 3400, considering the lot size, or a 2.56% return. Not too bad for 1 day, huh?

Takeaways

This is yet another example of the Ratio Spread, which in my opinion is the most useful strategy when you can find high IVs and price extremes together. We’ll keep pointing out these opportunities in #actionable as and when we find them. But now you know how to spot them and tackle them on your own. Good luck!

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