Sometimes I feel like a broken record regarding the US equity market lately. Take a look at any chart and you think you are looking at the same one you just analyzed. The stock went up, had a hiccup in mid October, then it’s off to the races again.
How do you define a top with a stock that continues to make all-time high after all-time high? By definition, there are no resistance points – the stock has never been to this price level before. Let’s take the example of the airlines sector. I love the sector. The price of jet fuel is one of the airlines’ biggest costs.
Domestic airlines in the U.S. spend a combined $2 to $5 billion on jet fuel every month. Needless to say, oil priced at $60 make it a lot easier to conduct business than when oil is at $100. At the same time, it’s not as if ticket prices have come down really at all. Good for the bottom line.
I don’t expect oil prices to spike back up any time soon, so I am looking for bullish plays. Take Southwest Airlines (LUV) for example. I would love to find some sort of bullish play, such as a vertical spread. How do I choose which strikes to target? My only indicator is to use the implied volatility for the desired time frame. Using the implied volatility, I can compute the measured move on any confidence interval I choose. I use a hybrid between a 50% confidence interval and a one-standard-deviation interval. My desired time frame is through January expiration.
Using January implied volatility of 36.82% and LUV trading $42.25 I computed a 50% CI of $45.96 and a one SD move of $47.20 to the upside. I identified buying the January 44/46 call vertical for $0.50. This has maximum gain of $1.50 with a maximum loss of $0.50 affording me a reward to risk ratio of 3:1.
