So if options are on average overpriced before earnings, why not to sell those options and hold the trade through earnings?
There are few ways to sell options before earnings to take advantage of IV crash.
One if through an Iron Condor. Many options sites do this strategy on a regular basis, based on high IV rank alone. I described here why selling options based on high IV rank alone might be not a smart move. The article described selling iron Condor on NFLX, based on the very high IV rank of NFLX options before earnings.
Unfortunately, NFLX is one of the worst stocks to trade this strategy. While options on average tend to be overpriced before earnings, NFLX is one of the exceptions. In fact, it moves on average more after earnings than the options imply. So there is no statistical edge to sell NFLX options. The opposite is true - there might be a statistical edge to actually buy them and hold through earnings.
Another strategy to take advantage of elevated IV is through a calendar spread, where you sell the near term options and buy longer term options.
So when you buy options before earnings (via straddle or strangle) you want the stock to move. If it does, the gamma gains will outpace the IV collapse.
When you sell options before earnings (through calendar or Iron Condor), you want the stock to stay relatively close to the current price.
In the straddle article, I described a TWTR trade from one of the options "gurus" that has lost 55%. The same guru recommended the following calendar spread before TXN earnings:
Sell -25 TXN OctWk4 53 Call
Buy 25 TXN Nov15 53 Call
The rationale of the trade:
Over the years, (TXN) has been one of my favorite earnings plays to trade. A very consistent winner, I have almost exclusively used a Neutral Calendar Spread on it, which is a strategy that takes advantage of over-priced options (high Implied Volatility) and time-decay. This strategy works best with stocks that have weekly options, and (TXN) has these available.
Historically, (TXN) is just not a very volatile stock. Every rare so often, even when the stock has moved more than expected, the Neutral Calendar Spreads hold up extremely well.
Last quarter, the stock had the following price movement after reporting earnings:
Jul 23, 2015 49.84 51.26 49.59 50.51 13,271,800 50.17
Jul 22, 2015 48.30 49.64 48.00 49.30 15,381,500 48.97
This trade is priced great, so recommend getting in as soon as possible. 10/10.
Fast forward to the next day after earnings: TXN gaped up 10%, and the calendar spread has lost 90%+. So much for "the Neutral Calendar Spreads hold up extremely well."
The rational behind holding calendars through earnings is that IV of the short options will collapse much more than the IV of the long options, so the short options will lose much more than the long options and the spread will make money. While this is true, the calendar will make money from IV collapse only if the stock doesn't move much after earnings. The rule of thumb is: look at the "expected move" as measured by ATM straddle value before earnings. If the stock moves less than the expected move after earnings, the calendar will make money. If it moves more, the calendar will lose money. And if it move much more than expected, the calendar will lose a lot, because the time value of both options will be close to zero.
And here lies the problem: even if you have a long term edge (buy straddle on stocks that move more than expected and buy calendar on stocks that move less than expected), from time to time those stocks will not behave "as expected, based on historical data", and the trades will be big losers. When this happens, there is nothing you can do to control the risk and minimize the loss.
That said, it doesn't mean you cannot use one of those strategies and hold through earnings, assuming you use the right strategy for the right stocks. But you need to assume a 100% loss right front, be fully aware of the risk and use the correct position sizing. Those options "gurus" who fail to even mention the risks don't do their job properly.
We invite you to join us and learn how we trade our options strategies in a less risky way.