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Selling Strangles Prior to Earnings


Question from a reader: What is your opinion on a short strangle vs a short straddle? I understand the same unlimited risk will be there because you are trading naked options. I found that one strategy I have had some success with in paper trading is using short strangles around earnings to take advantage of large drops in volatility.

I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play.

 

Mark's response:

 

1) To me they are the same, with the straddle being a subset of the strangle  In other words, a straddle is merely a strangle when the strikes and expiration dates are the same.

 

I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike.  I prefer to sell OTM calls and puts – and that's not possible with a straddle.

 

As far as unlimited risk is concerned, that's a decision for each trader.  I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post.

 

2) A clarification.  In is not 'volatility' that incurs a large decrease after the news is released.  Instead it is the implied volatility of the options.  I'm fairly certain that is what you meant to say.

 

3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be.

 

4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news."  The market has made an estimate of how much the stock price is likely to move.  Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated.

 

There is no formal prediction of move size.  There is nothing that says the stock will move 6.35 points.  What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options.  And it makes no difference if they are calls or puts.  At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured. 

 

From the IV, the 'anticipated move' for the underlying is determined.  AsI said, it's not as is everyone agreed on how much the stock will move.

 

I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move.  Many times the move is far less than expected.  That's the reason why selling options prior to earnings can be very profitable.  The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts.

 

However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV decrease doesn't do a whole lot of good.  Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money.

 

Also remember that part of the time that stock price gaps by far more than expected.  In that scenario, a higher quantity of formerly OTM options are now ITM.  Thus, large losses are not only possible, but they are more frequent that you realize.  Apparently your trades have worked out well (so far).

 

Think about this:  If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago.  The truth is that these option buyers collect often enough to keep them coming back for more. 

 

5) That means you must be selective in which options you sell into earnings news.  This is especially true when you elect to sell naked options.  You cannot options on every stock, hoping that any random play will work.  This is a high risk/high reward game.  It's okay to participate, but please be aware of what you are doing and the risk involved.

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Mark, You are back! Just today I picked up your Rookies books and re-read the chapters on diagonals (for about the 20th time). When you wrote the second edition you added a chapter for calendars and also some additional material on diagonals. With regard to volatility (IV) and also VIX would you say that a trade consideration should be low put volatility for entry and bank on the high theta for the short side?

 

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