When Options Get Too Cheap to Hold

Life Cycle of a Trade: PayPal Strangle – Detailed Summary

Key Concepts:

• Strangle: An options strategy involving simultaneously selling an out-of-the-money (OTM) call and an OTM put with the same expiration date.
• Implied Volatility (IV): A measure of the market's expectation of future price volatility.
• IV Rank: A percentile ranking of the current implied volatility compared to its historical range.
• Delta: A measure of an option's sensitivity to a $1 change in the underlying asset's price. Short delta means the position benefits from a price decrease (for calls) or increase (for puts).
• Skew: The difference in implied volatility between call and put options with the same expiration date.
• Break-Even Point: The price at which the trade becomes profitable.
• Roll Up (of an option): Closing an existing option position and opening a new one with a higher strike price (for puts) or lower strike price (for calls).
• Binary Event: An event with a limited number of outcomes, often with significant price impact (e.g., earnings release).

1. Initial Trade Setup: The Strangle in PayPal (PYPL)

The trader initiates a strangle on PayPal (PYPL) due to its recent rally (from mid-$60s to mid-$80s) and relatively high implied volatility (IV Rank of 63). Earnings are anticipated in early February, contributing to heightened volatility, particularly in the February 7th expiration (47% IV) compared to subsequent expirations (46%, 43%). Despite the earnings risk, the trader proceeds with a small position size (one contract) to facilitate manageable risk. The goal is to collect premium, capitalizing on elevated volatility and the VIX being somewhat elevated.

The specific trade involves:

• Selling a 77.50 Put: Delta of 19, aiming for a slightly bearish lean, potentially benefiting from a pullback to fill a gap around the $75 handle.
• Selling a 95 Call: Delta of 31, anticipating limited upside continuation after the recent rally.
• Net Delta: Short 12 deltas, indicating a slight directional bias towards a downward move. The trader acknowledges the call side has a closer risk profile due to skew.

The trade generates a credit of $384, requiring approximately $1,000 in buying power, representing a potentially high return on capital with a target profit of around $100. The probability of success is estimated at 66%.

2. Monitoring and Adjustment Before Earnings

Approximately three weeks after initiating the strangle, the trade has moved favorably, increasing in value by $0.73. With earnings approaching (February 4th), the trader assesses the situation. The focus is on capturing the volatility expansion associated with earnings.

The trader observes a significant volatility differential between the February (high 50s) and March (low 40s/30s) expirations, representing a potential profit opportunity from sideways or limited movement. The trader aims for at least $1 of premium across all positions.

3. Rolling Up the Put Option

The 77.50 put option has lost approximately half its value, trading at $0.64 (originally sold at $1.36). The trader decides to “roll up” the put to the 84 strike to collect additional premium and adjust the risk profile.

• Rationale: The original put is too cheap to hold given the downside risk. Rolling up allows for increased premium capture, potentially offsetting losses if the stock remains stable or moves slightly higher.
• Delta Neutrality: The roll-up aims to reduce the overall short delta of the position. The initial position had a net delta of approximately 24-25. The roll-up is designed to bring the net delta closer to zero, reducing directional risk.
• Execution: The put is rolled to the 84 strike for $0.93, bringing the total credit received for the position to $4.70. This adjustment results in a net short delta of approximately 10.

4. Closing the Position Before Earnings

Prior to earnings release, the position is up approximately $114-$115 (total credit of $4.70 versus a mid-price of $3.63). The expected move for PayPal during earnings is around $7.

• Risk Assessment: The trader recognizes the binary nature of the earnings event and the potential for a significant price swing in either direction.
• Profit Taking: With profits secured, the trader decides to close the position to avoid the risk of losing those gains during the volatile earnings period.
• Execution: The position is closed at $3.67, resulting in a net profit of $110. The trader highlights the price improvement achieved during the trade execution.

5. Key Arguments and Perspectives

The trader emphasizes a risk-managed approach, utilizing small position sizes and actively adjusting the trade based on changing market conditions. The strategy focuses on capitalizing on elevated volatility, particularly around anticipated events like earnings releases. The decision to close the position before earnings demonstrates a preference for preserving profits over attempting to capture further gains in a high-uncertainty environment. The trader prioritizes a dollar of premium across positions as a risk/reward benchmark.

6. Notable Quotes

• “I’m looking to get some short premium on with the VIX a little bit elevated here and volatility in PayPal itself relatively high.”
• “Avoiding earnings was the key to this adjustment and close.”

7. Data and Statistics

• PayPal Stock Price: Rally from mid-$60s to mid-$80s.
• IV Rank (PayPal): 63
• February 7th Expiration IV: 47%
• Subsequent Expiration IVs: 46%, 43%
• Initial Credit: $384
• Buying Power Required: $1,000
• Target Profit: $100
• Probability of Success: 66%
• Earnings Expected Move: $7
• Final Profit: $110

Conclusion:

This trade exemplifies a volatility-based options strategy focused on premium collection. The trader successfully navigated the position through changing market conditions, proactively adjusting the put option to optimize risk and reward. The ultimate decision to close the position before earnings highlights a disciplined approach to risk management and a willingness to secure profits rather than gamble on a binary event. The detailed breakdown of the trade provides valuable insights into the thought process behind options trading, emphasizing the importance of understanding volatility, delta, and the impact of events like earnings releases.