Making drones work for you

Stories involving drones have been a mix of science fiction, military strategy and future commerce. Think of the 1960’s cartoon, The Jetsons.

The technical name for a drone is Unmanned Aerial Vehicle (UAV). A UAV can be either remotely piloted or it can be an autonomous vehicle. The history of drones dates as far back as 1849. Austrians equipped balloons with bombs that had timing devices on their fuses. The intended target was Venice. The wind was not correctly accounted for, however. As many bombs blew back across Austrian lines as there were exploded over Venice.

The first large scale production of drones occurred during World War II. About 15,000 radio-controlled planes were produced by a firm owned by Reginald Denny, who was a British World War I vet and Hollywood actor. He starred in the Adam West Batman series and movie.

The drones were used mainly for target practice for anti-aircraft guns. During the Cold War two UAVs were flown over Bikini Atoll after the H-Bomb was detonated where they collected radioactive data.

In 1982 when Israel destroyed the Syrian air force, half of the Israeli force was composed of UAVs. The Iraq War saw an extended use of drones. U.S. border patrol uses UAVs as their primary means of reconnaissance. Amazon (AMZN) has toyed with the use of UAVs for delivery of its packages. And the availability of recreational drones to hobbyists has become so widespread that air safety has become a big question.

What are the stocks that are expected to grow with the advance of UAVs? AMZN would be one candidate. Boeing (BA) is already producing many of the vehicles. AeroVironment (AVAV) is the leading producer of support systems for intelligence gathering drones. FLIR Systems (FLIR) and Northrop Grumman (NOC) both produce large military drones. NVIDIA (NVDA) provides artificial intelligence for drones. Boeing and Amazon are both highly capitalized stocks with a great deal of liquidity in both their stock and listed options. If Northrop Grumman or FLIR Systems exceed one million shares in volume in a day, it’s just barely. They have no options with an open interest above 1,000. AVAV isn’t much better, although it does have one options series with an open interest above 1,000. NVDA has an average daily volume of more than 11 million shares. NVDA has dozens of listed options with open interest above 1,000. FLIR and AVAV might be a good buy in a buy and hold strategy but they’re not good stocks for active trading. NVDA is a good trade candidate.

NVDA has mostly been in the news regarding driverless cars. The same expertise in artificial intelligence is being applied to UAVs as well. In 1999 NVDA issued its IPO at a price of $19.69. It has since split 12 times and is trading around $250. Its 52-week range is between $152 and $269. It is at the high end of its range, but it has a reasonable P/E ratio of 42.

With NVDA trading at $247.53, the 2019 January 195 puts have a bid/ask of 6.10-6.30 and the 2019 January 300 calls have a bid/ask of 8.00-8.25. In contrast, with SPY trading at 278.50 the 2019 January 225 puts are trading at 1.75 while the 2019 January 335 calls are trading at 0.08. SPY obviously moves much faster to the downside than it does to the upside. NVDA moves with approximately the same speed to both the upside and the downside. 

With that in mind, we want to fashion an option strategy that will profit from a continued rise in NVDA with protection if it retreats. We came up with a delta neutral upside ratio spread.

The NVDA 2019 January 290 calls have bid/ask of 10.35-10.55 with a delta of 31 (mid-July) while 2019 January 265 calls have a bid/ask of 18.45-18.70 with a delta of 46. Delta measures the degree to which an option is exposed to shifts in the price of the underlying asset. In the case of stocks, it equates to the amount of shares an option is equivalent to at a specific price. You can buy three 290 calls and sell two 265 calls and remain delta neutral. A 30X20 spread would produce only 10 positive deltas. The daily decay for the entire spread would be only $40. That number increases exponentially, however, when you get closer to expiration. This position would have positive vega of 470. That means that if premium levels increased there would be increased profits and if premium levels declined, increased losses. However, there is no directional bias in terms of premium levels.

This delta neutral upside ratio spread would produce $5,650 if NVDA closes below $265 at expiration. In other words, if NVDA drops or rallies less than 7.5% you collect that. The best-case scenario would be a quick move to the upside or a steady move to the downside, which would produce higher premiums before time decay increases more rapidly (see chart below).

The worst-case scenario for this trade occurs at expiration with NVDA at $290. Your long calls expire worthless and you would lose $6.45 on your short calls, resulting in a total loss of $44,250. But you would or should not let that happen. Traders would bank profits on an early rally or alter the position two months before expiration.

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.