Calendar-Straddle combo?

[samerh 6]

Could someone please explain to me why a calendar and straddle combo wouldn't work as an almost risk-free on an earnings play? On the assumption that there is no such thing as a free lunch - what am I missing?

 

From the first picture, calendar and straddle on CMG, 2 days before earnings. Looking at the chart and greeks:

• Theta is positive so time is on your side
• At expiration, no parts of the graph are negative
• Vega is positive and as IV typically increases as we approach earnings this should also be good.

 

I understand that if there is a significant IV drop, the whole middle part of the red line goes under (second picture), but that shouldn't happen on the run-up to earnings.

 

 

[Kim 7,943]

Just to clarify - are you suggesting this trade as holding through earnings or still selling before the announcement? 

[samerh 6]

Selling before announcement just as we do with our regular straddles.

 

To be clear - I'm sure I'm missing something, seems too easy.

 

(for the second picture I adjusted -10%vol which isn't shown)

[Kim 7,943]

Well, I don't think you are missing anything. The P/L is not very accurate since those trades are much more sensitive to IV changes than price changes. The calendars are very resilient to fairly large moves (check out some of our previous calendars). So if the stock moves, the straddle should make money, and the calendars will make or lose based more on IV spreads between the long/short options and less based on a move. But if the stock stays near the current prices, and IV of the far month is down, the combined trade can still lose money.

[Ice101781 3]

I looked at a structure like this myself just today.

 

Also, consider your portfolio allocation for this trade. The net debit would be $3415.00 + commissions for just one spread. Assuming a 10k portfolio, that's over 1/3 allocation for just one trade. And, as you and Kim both mentioned, an IV drop would do some damage at that allocation. 

 

Question: how did you produce the second graph in TOS where IV drops 10% hypothetically?

[Kim 7,943]

To reduce the cost, you can do a strangle instead of the straddle.

[samerh 6]

Ice: click on the wrench icon and then you can adjust vol - I've highlighted them in the pic.

 

 

[Ice101781 3]

good point Kim --

 

thanks sam!

[jfouche 12]

The theta will not actually help here because almost all the premium is tied to earnings, and TOS doesnt know this. The two positions both play IV. Look at past calendars on SO where the stock sometimes went nowhere, but IV had to rise before we could exit.

If you move to strangle instead of straddle you end up with a kind of double diagonal, which has its own special properties.. It would profit on a massive move and maybe zero move, but lose $ on medium size moves between the strangle strikes.

[samerh 6]

The theta will not actually help here because almost all the premium is tied to earnings, and TOS doesnt know this. 

 

 

Thanks.

 

I get the part about it being a play on IV.

 

Could you please expand a little/give detail on how almost all the premium is tied to earnings and not in the time value?

[jfouche 12]

If we play a random calendar on a stock with no event, we will profit from time decay like TOS expects on a day with the underlying unchanged. This is different.. Here, the model thinks several days of intense moves are expected in July, but really it is only one big jump.

So TOS thinks the July options should rapidly decay each day, but it really happens all at once after we react to the news.

It may help to think about what would happen if the report was postponed to after July expiration.

The July options would be worth very little and the calendar would be a huge win. And if it was put off to September you would be nearly wiped out on the straddle, with the calendar maybe a small win at best.

[Kim 7,943]

Good explanation jfouche.

 

The theta might help a little bit if IV increase of the short options is not enough to offset the theta. This is what is happening now to CMG and SNDK trades. They are losing money because the vega is not catching up to theta - imagine we are on the other side of the trade, shorting them.