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Wednesday, October 11, 2006

Trade Review - VTS Straddle

This trade review is overdue. And I told myself I gotta get it done today. Ok, I got slammed in the face by this *straddle* game which I took out for VTS earnings.
*Straddle is defined as call + put combination at same strike, same mth


Q1)Why did I enter?
-Becos based on the past few earnings anouncement, this co. has a min. movement of abt $4. Great moves, I told myself.
-Next I checked the volatility: Historical @48.5, IV @33.7. IV is still lower than HV, even better!
-At point of entry, stock price @64. Not too bad, its pretty close to the strike price, a condition which must be fulfilled before I do a straddle play.
-I ran the options calculator to estimate what my losses wld be in the worst case scenario, i.e stock moves sideways, time decay, IV collapse. Hmm, but wait a minute, since the IV is lower than HV, there is no IV collapse to talk abt. I did noticed that IV fell to 20s early Sep, right after co. announced merger. But heck, it can't go THAT low again I guess. Moreover, months prior to the merger news, the IV has been looking at an avg of 40. So I made do with downing the IV to just 30 for worst case scenario. Potential loss seems very acceptable in worst case scenario. Great! I was very excited, but I had a naggy feeling abt this trade....as I told my COO..but I went ahead nevertheless. I will talk more abt this naggy feeling later...

Q2)What & When did I buy?
Oct65 straddle @3.7 on 4/10. Company to announce earnings AMC that day

Q3)What happened after earnings released?
-Day 0:It announced $0.25 EPS vs Reuters estimates of $0.42. Revenues $178.4 mln vs $186 mln consensus. VERY lousy results. Good, looks like the market will thrash this stock.
-Day 1: But stock was flat as pancake the next trading day. And I realised that my straddle price is falling like a stone even though stock price has not really moved much. I immediately checked the IV. True enough, IV dropped to low 20s! Although it tried to make a dash towards 65 when it opened(which I can't justify given the very poor results), most of the day it was hovering bet. 64-65. Worse, I also noticed that volume was low compared to last few earnings release. Its not a good feeling, I knew I was dead meat if it continues in such directionless move. I decided to give it another day to move, and win lose or draw, I will close it before the weekends.
-Day 2 (6/10): I closed out my losing position @2.5, because it is not making the moves that I expected it to make

Q3)What went wrong & lesson learnt?
You remembered me talking abt the naggy feeling? The truth is, I noticed this stock for potential earnings the weekend before they are due to announced earnings. But I saw a big gap up in VTS chart in early Sep & found out that its due to a merger news. I have this subconscious feeling that the merger will limit the stock's ability to move big becos the price for the merger has already been agreed on. Nevertheless, I decided to ask my mentor. Expectedly, she told us that news doesn't bother her (She is not a news-driven trader, more of technical-driven trader), & that she has traded VTS for earnings in the past with good results, so she is going to keep this stock in mind closer to earnings.

Unfortunately, I think the merger did have an impact on this stock's earnings move and the trading volume after earnings confirmed that.And the real IV was probably closer to 20s than 30s now becos the merger news kind of change the whole landscape for this stock IV. I'm glad I closed this position early, becos you can see from the chart that the stock is not exactly going anywhere these few days & time decay (I bought Oct contracts) would have killed me even more if I hang on.

This is definitely the worst straddle trade for earnings I've had to date. I'm not blaming my mentor for this. No doubt her views gave me the reassurance to go ahead with this straddle, but as a trader, one should hold FULL responsibility for your own trades. And I only have myself to blame for not trusting my own intuition. But well, looking at it more positively, this trade has taught me to avoid co. that are in process of merging/being acquired for earnings play. And I paid the market to learn this lesson.

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