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Morning Matters:

How Not To Trade Options
by Geoff Garbacz

In Monday's Wall Street Journal, there was an "interesting" article in the options column written by Brendon Conway. The title of the article was "How To Play Puts and Calls In Less Volatile Markets".

As one of the contributors to www.goldandenergyoptionstrader.com, I think I can weigh in on this article. The first premise of the article is that the VIX is returning to a more "normal" level. There is no measurement offered in the article that the VIX is falling other than that it has dropped from above 40 to the mid 20s.

The process we use in GEOT is akin to The Madison Letter where the recent range is determine not how much it has risen or fallen. For this the buy,hold and sell points of the VIX from the Madison ranks are used.

Currently, these points are 40.16, 30.90 and 21.64. This range depicts that the VIX is at the low end of its range as it closed last night at 24.88. A move higher in the VIX could be forthcoming. The net is that relative is what matters and the if the VIX rises as we believe it might then the second premise for the article could really be put through the ringer.

The unknown comic was famous in the late 1970s. Now we have the "unknown analayst" who is mentioned in the article. He is mentioned if you want to read the article but for purpposes of our column we will leave his name out of our comments.

The unknown analyst argues for buying calls and selling puts. The example in the article given is not an energy or material name but Mastercard (MA). It is suggested one buy an October $240 call for $6.41 and sell a $190 put for $8.90. The credit is $2.49. The position makes money if Mastercard rises by 13% when the October expiration takes place. This is four month away. The trade loses money on a drop below $187.53. The stock closed at $214 on Friday.

Quite honestly, the chart looks like a revisit of $190 could be in the cards and a break could take it to $160. This results would be a horrendous loss.

Here is the rub with this trade. If the VIX is going to rise between now and October, there is a good chance that Mastercard could get hit. Second there is a big event looming for Mastercard and Visa. The fate of these companies lies in the hands of Congress as pending cuts for transactions fees on credit and debit cards awaits these companies. If and when the fees get cut, then the business models of Mastercard and Visa could get hit.

The third problem with this trade is that the overall market is now in a seasonally weak period from now until October. Moreover, the seasonal pattern of Mastercard since it went public is poor as well.

The bet being made is that the stock will rise by 13% in the next four months. That could be a tough bet with the above headwinds. Too much of the analysis on this trade is built on options pricing, but even this is flawed, and not enough on event risk analysis. The option market agrees.

The implied 20 day volatility which is a VIX on a stock is at 35 while the forecast is 36. If the premise of this trade is correct, then the forecasted volatility should be moving lower. The thought that Mastercard can rise looks to be flawed.

A better strategy we believe is to make a directional bet. Such a bet or strategy makes sense when the trend is getting jiggy or a reversal is imminent.

The chart of Mastercard is telling. The chart is broken and simply in a dead cat bounce. Volume sees more sellers than buyers. Rallies will be sold.

For the above reasons, one should eschew the volatility arbitrage employed for Mastercard as it is riddled with errors that come about from variables that cannot be modeled. We prefer to model such risk in a subjective manner. Figure out the odds of the events identified coming home to roost and how the chart is progressing from several vantage points. A directional bet makes more sense and it seems that buying puts or putting on a put spread would make more sense.

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