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Why We Sell Our Calendars Before Earnings


In my previous article I described why we sell our earnings straddles before earnings. As a reminder: “There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. There is no reliable method for predicting such an event. The opposite case is much more common – pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike.”

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 crush.

 

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.

 

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Everything mentioned in this article is true. You can go ahead with these strategies provided you are ready for 100% loss in case something bad happens and it will happen . 

I have seen articles where people trade triple calendars to cover wide range. Most of the time it may have been 10 to 20 % winner say for e.g in GOOG.  But if you were there in that trade when GOOG moved 150 points and if you are still in business, you will never try this again.

 

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Guest Franc

Posted

Hi,

i am a bit confused about stock IV rank and options IV rank.

I have never seen options IV rank before, what is it?

In the article above i read:" ....very high IV rank of NFLX options before earnings ". 

 

Thanks

Franc

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Google search for IV rank gives the following result - https://www.tastytrade.com/tt/learn/iv-rank:

IV rank is our favorite volatility measure at tastytrade. IV rank simply tells us whether implied volatility is high or low in a specific underlying based on the past year of IV data. For example, if XYZ has had an IV between 30 and 60 over the past year and IV is currently at 45, XYZ would have an IV rank of 50%. Since all underlyings have unique IV ranges, stating an arbitrary IV number does not help us decide how we should proceed with a strategy. 

The problem with basing trades on IV rank is that IV is usually high for a reason. You cannot just say "we sell options based on high IV rank". In many cases (like NFLX) stocks move more than implied by options, so selling options based on IV rank in those cases is not a prudent move.

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Guest Curious

Posted

I have a question. I tried a calendar on $NFLX recently and got crushed. What I realized, after the fact, that it was due to the sudden drop in implied volatility the next day, even though $NFLX was moving down strongly. I purchased my calendar spread the day of the of earnings when the prices (and vol) were high. 

I am wondering, if I purchase the spread a week ahead of time, when the vol is lower and then sell the day of the announcement, when vol is highest, will this work and is there another Greek waiting to bite me? 

Thanks in advance!!

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Guest Calendar Spreads - Earning

Posted

10 hours ago, Kim said:

If you could post the details of the trade, I might be able to comment.

I was looking at $AMZN 985 Call OCT 27/NOV 3 call spread. I've been researching. I think I was trying to over simplify things. My $NFLX trade, the vol was high when I purchased. On the next day, after earnings, the vol dropped significantly, but I think the vol on the near term didn't drop as severely as the longer term, resulting in my trade going bad. I've looked and I might be in the same situation with this trade, due to earnings. In my mind, it was the sever drop of vol, not the ratio or skew. I was thinking that as the vol increased on the day of earnings, that the opposite would happen. Looking at expected vol for the next few weeks, as well as historical vol over earnings for $AMZN, I'll be in the same boat. I found a way to adjus far and near expiration vol separately on TOS. Guess this isn't the best spread over earnings. 

If you have any tips though, I would greatly appreciate them. 

 

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On 7/20/2016 at 2:07 PM, mukundaa said:

Everything mentioned in this article is true. You can go ahead with these strategies provided you are ready for 100% loss in case something bad happens and it will happen . 

I have seen articles where people trade triple calendars to cover wide range. Most of the time it may have been 10 to 20 % winner say for e.g in GOOG.  But if you were there in that trade when GOOG moved 150 points and if you are still in business, you will never try this again.

 

Hi mukandaa. When has GOOG moved 150 points in the weeks prior to earnings? I don't remember this happening. Is this a hypothetical example? 

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On 2017-03-24 at 9:38 AM, Kim said:

Google search for IV rank gives the following result - https://www.tastytrade.com/tt/learn/iv-rank:

IV rank is our favorite volatility measure at tastytrade. IV rank simply tells us whether implied volatility is high or low in a specific underlying based on the past year of IV data. For example, if XYZ has had an IV between 30 and 60 over the past year and IV is currently at 45, XYZ would have an IV rank of 50%. Since all underlyings have unique IV ranges, stating an arbitrary IV number does not help us decide how we should proceed with a strategy. 

The problem with basing trades on IV rank is that IV is usually high for a reason. You cannot just say "we sell options based on high IV rank". In many cases (like NFLX) stocks move more than implied by options, so selling options based on IV rank in those cases is not a prudent move.

@Kim There is also IV Percentile. And I think sometimes traders and providers substitute these meanings.

http://tastytradenetwork.squarespace.com/tt/blog/implied-volatility-rank-and-percentile

 

Edited by IgorK

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On 10/21/2017 at 2:07 AM, Guest Calendar Spreads - Earning said:

I was looking at $AMZN 985 Call OCT 27/NOV 3 call spread. I've been researching. I think I was trying to over simplify things. My $NFLX trade, the vol was high when I purchased. On the next day, after earnings, the vol dropped significantly, but I think the vol on the near term didn't drop as severely as the longer term, resulting in my trade going bad. I've looked and I might be in the same situation with this trade, due to earnings. In my mind, it was the sever drop of vol, not the ratio or skew. I was thinking that as the vol increased on the day of earnings, that the opposite would happen. Looking at expected vol for the next few weeks, as well as historical vol over earnings for $AMZN, I'll be in the same boat. I found a way to adjus far and near expiration vol separately on TOS. Guess this isn't the best spread over earnings. 

If you have any tips though, I would greatly appreciate them. 

 

This is the setup we usually trade - however, you really need to be sensitive to the price. We do extensive backtesting and enter only when the prices are right, compared to previous cycles.

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Guest Glad I sold BEFORE earning

Posted

On 10/22/2017 at 6:31 PM, Kim said:

This is the setup we usually trade - however, you really need to be sensitive to the price. We do extensive backtesting and enter only when the prices are right, compared to previous cycles.

Well, I sold before earning for a very small profit and glad that I did. Using the previous IV on the options over past earnings suggested this position could have won big had the IV decreased in a similar matter. In previous earnings the near term vol went from 80% to below 10%, while the long term went from around 40% to 20%. This looked like a possible win on the simulator. In those previous earnings, the price changed around $20 - $30, initially and moved closer towards the pre-earnings price the next day.

In this last earnings, $AMZN had a blowout quarter and the price moved up over $40 initially and up over $70 the next day. Vol on the near term (even though expiring the next day) went through the roof and was up over 110%, while the far term decreased slightly, absolutely crushing the calendar spread. 

Conclusion: Sell before earnings. Anything else is taking a huge risk. Either price or vol crush can kill a calendar spread. Better off using a defined risk strategy and gambiling up/ down on the reaction. 

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