The Case of a Smooth Trend

The previous post considered several strategies to buy volatility low and sell it high when the underlying security experienced a sharp price change.

I want to look now at the case of a trending price in the underlying stock. The following chart shows the price of eBay (EBAY) in the past three months:



Not only the price decline is well defined and quite smooth from June onward but the historical volatility as measured by the price standard deviation is pretty much constant.

This chart shows EBAY historical volatility and implied volatility over the same period of time:



It is interesting that historical volatility had been decreasing since the big jump in May but implied volatility had been steadily on the rise. The opposite has been happening since the first half of July.

Let's consider again options that were at the money in the middle of June, that is when EBAY was selling for about $30.5.

The following chart shows the price of XBAHF, the August call with strike at $30:



This chart shows the price of XBATF, the August put with strike at $30:



Now let's look at the following fantasy trades:

Buy 50 shares of EBAY at $30.5 and one XBATF contract at 100 times $2, then sell EBAY at $33.5 and XBATF at 100 times $6.75. The net profit, excluding commissions, would be $125, that is 7%.

Sell short 50 shares of EBAY at $30.5 and buy one XBAHF contract at 100 times $2.375, then cover EBAY at $23.5 and let XBAHF expire worthless. The net profit would now be $112.5.

Buy one XBAHF contract at 100 times $2.375 and one XBATF contract at 100 times $2, then sell XBATF at 100 times $6.75 and let XBAHF expire worthless. The resulting profit would be $237.5, that is 54%.

I want to check what happens if instead of using options expiring in August I use options expiring in January 2007.

This is the chart of XBAAF, January call with strike at $30:



And this is the chart of XBAMF, January put with strike at $30:



Buy 50 shares of EBAY at $30.5 and one XBAMF contract at 100 times $3.25, then sell EBAY at $33.5 and XBAMF at 100 times $7.25. The net profit, excluding commissions, would be $50, that is 3%.

Sell short 50 shares of EBAY at $30.5 and buy one XBAAF contract at 100 times $4.25, then cover EBAY at $23.5 and sell XBAAF at 100 times $1.25. The net profit would again be $50.

Buy one XBAAF contract at 100 times $4.25 and one XBAMF contract at 100 times $3.25, then sell XBAMF at 100 times $7.25 and XBAAF at 100 times $1.25. The resulting profit would be $100, that is 13%.

Categories: stock options, volatility, delta neutral
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