Investing Advice: PEPE Trade

Posted On August 13, 2018 2:56 pm

For today’s investing advice, here’s a conservative way to play earnings before the report to earn 30% per week with little risk.

We use a combination of calendar spreads to take advantage the differentials in time decay and implied volatility heading into an earnings to produce very consistent returns.

I call this a Pre-Earnings Premium Expansion, or PEPE, trade.

Here’s a play I’m making this week.

Kohls (KSS) is set to report earnings next Tuesday August 8/21 before the market opens.

The nature of options pricing is to build into the premium how much the stock is expected to move within a given time period.  This is expressed in the implied volatility.

You can see from KSS’s option chain that the 8/17 expiration, which contains the earnings event, carries an IV of around 61% which is significantly higher than this week’s 8/17 expiration and the following week’s 8/31 expiration which have IV’s 42% and 50% respectively.

You can also see this week’s options will decay, or have higher theta, than next week’s options.  The above option chain above shows this week’s 76.5 calls will lose 17c per day—which will accelerate, while next week’s lose just 15c per day—a rate will remain stable for the next few days.

This ‘hump’ in the term structure of the options may actually get steeper as the week goes on as traders continue to pump of the 8/24 options that highlight the earnings.

You can see below the pattern of IV (the gold line) rises dramatically heading into each quarters earnings report.

Source: iVolatility.com

I want to take advantage of the differentials in pricing behavior between these two expiration periods by establishing a double calendar spread.

This is done by selling this week’s puts and calls and buying next week’s puts and calls with the same strike price.

The order would look like this:

I’m willing to pay up to $3.50 debit for this position.

Note the highlighted premiums for the weekly options; they add up to approximately $1.40.  I expect these to go to zero by Friday position.

While I expect put and call I own with next week’s expiration will retain all their premium in anticipation of the earnings event.

Meaning I will collect that $1.40 of weekly premium .

This is a 40% return on my initial $3.40 cost in just 4 days as I plan on closing the position by end of Friday.  And it comes with next to no risk.

If you want to learn more about PEPE or other option strategies  sign up for my Options360 service here.

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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