Pre-Earnings Dbl Cal vs Staddle/Strangle (or maybe a hybrid)

[Yowster 9,183]

There have been quite a few posts recently about when to use the straddle/strangle pre-earnings strategy and when to use the double calendars.  Kim has indicated that he prefers the DCs when back testings shows that the weekly straddle/strangle under-performs the monthlies - and also the DCs only make sense for higher priced stocks (because otherwise the commissions make up too high a percentage of the trade cost).

 

I believe the pro's and con's of each are:

• The straddle/strangle benefits from IV increase prior to earnings that will hopefully outpace theta time decay.  They also benefit from larger stock price moves.  Working against the straddle/strangles are no price movement in the stock prior to earnings and IV increases not off-setting theta (or IV dropping in general).
• DC's benefit from the weekly options losing their value quicker than the monthlies.  They should also benefit to some degree as IV increases.  The main thing working against the DC's are large price moves in the underlying stock (although its less of a negative when compared to non-earnings calendar spreads).  DC's could also suffer if the weeklies start to out-perform the monthlies by a larger degree.

This got me thinking of a strategy to take the best of both approaches, and the thing that came to mind was a double-diagonal.  I haven't done any back-testing, but it may be worth it to paper trade this approach to see how it compares with the DC.

 

For example, PCLN is a high-priced stock coming up on earnings next week, and in Kim's trade discussion topic he's leaning towards a DC (although I'm not sure what strikes he's looking at).   But for the sake of this example with PCLN around $890, lets assume that we'd do a DC with 880 puts and 900 calls where we are long the August monthlies and short the August week 2's.   The double-diagonal to compare this against would be that we are still long the monthly 880p and 900c, but for the short legs we go one more strike OTM and sell the week2 875p and 905c.   My thinking is that we'd still benefit from the monthlies out-performing the weeklies (although maybe by a slightly lesser degree) but we'd also benefit more from larger price swings in the stock prior to earnings.   This would also offer some protection against the worst-case DC scenario where earnings are announced prior to the published date and accompanied by a very large stock move (admittedly rare, but it does happen) - in this case the DCs would lose almost all of their value, but the double-diagonal would not have as big of a loss.

Edited August 1, 2013 by Yowster

[dbh21 62]

I'm not sure if I am doing this correct, but when I price your PCLN diagonal vs the Double Cal, the diagonal requires about 2.5X the capital. Is that what you see?

[Yowster 9,183]

Yes, that sounds about right.  The short strikes you are selling are farther out of the money than the long strikes you are buying so its going to require more capital when you open the trade.   

[dbh21 62]

I don't have a lot of experience with DblDiags. But isn't that alone going to significantly bite into your profit margin? Maybe its lower risk because they are further out strikes, but in this example they are not giving 2.5 times the risk protection. I used TOS to compare the DblCal to the DblDiag, and when you inflate the vol, the tents both seem to move about the same.

[Yowster 9,183]

I'm going to paper trade the DblDiags vs the DC's on the next few higher prices stocks that come up for earnings and see how things play out - starting the analysis at 5 days before earnings (I've started tracking this on PCLN as of this afternoon).  I would expect the DC's to outperform the DblDiags when the stock price movement is minimal, but I'm hoping to see the DblDiags outperform the DCs where there is some decent price movement prior to earnings.  The majority of the gains in the DC's come from the monthlies outperforming the weeklies as the IV increases.  The DblDiag should benefit from this too (to a slightly lesser degree) but they should also benefit from stock price movement.

 

Another way to think about the DblDIags is similar to the RIC pre-earnings trades that Kim makes during times of higher market IV.  The difference is the long strikes are the monthlies and short strikes are the weeklies.

 

From a trade management perspective, I can see scenarios where it would make sense to change the diagonal to a calendar on one or both legs at some point during the lifetime of the trade.

[Micahjw 3]

Interesting discussion - let us know the results of your paper trading on the double diags.

[Hany 1]

Can someone point me to the recent discussions about when to use the straddle/strangle pre-earnings strategy and when to use the double calendars? 

[Yowster 9,183]

Here are my stats for the PCLN Double Calendar compared to Double Diagonal.  First a few notes on the numbers:

• Prices were noted each day around 3:00 and used mid point prices (although we all know that PCLN option prices jump a lot during the day and mid point prices were not always easy to fill).
• Commission not included.
• No trade adjustments were made (although if this was a real trade adjustments may have been warranted).

Earnings Date -5 Days    

Stock Price $905.00    

Dbl Cal $3.65   Short Aug9 890p/920c, Long Aug16 890p/920c

Dbl Diag $7.35   Short Aug9 885p/925c, Long Aug16 890p/920c        

 

Earnings Date -4 Days    

Stock Price $910.10    

Dbl Cal $4.75   Gain = $1.10 (+30.1%)

Dbl Diag $9.15   Gain = $1.80 (+24.5%)        

 

Earnings Date -3  Days    

Stock Price $927.30    

Dbl Cal $5.00   Gain = $1.35 (+37.0%)

Dbl Diag $9.15   Gain = $1.80 (+24.5%)        

 

Earnings Date -2 Days    

Stock Price $937.90    

Dbl Cal $4.25   Gain = $0.60 (+16.4%)

Dbl Diag $8.80   Gain = $1.45 (+19.7%)        

 

Earnings Date -1 Days    

Stock Price $927.50    

Dbl Cal $4.55   Gain = $0.90 (+24.6%)

Dbl Diag $8.70   Gain = $1.35 (+18.4%)        

 

Earnings Date -0 Days    

Stock Price $933.80    

Dbl Cal $5.00   Gain = $1.35 (+37.0%)

Dbl Diag $9.15   Gain = $1.80 (+24.5%)

 

Some observations:

• For both the DC and DD, the price jump after the first day was the biggest jump.
• From a percentage perspective, the DC did a little better when the strikes were OTM or ATM.
• When the strikes got deeper ITM, the DD started to fair better - implying that if the stock price spiked up and didn't give you time to adjust your trade then the DD would be better than the DC in this case.
• DD strategy only makes sense for very high priced stocks or for moderate priced ones where strikes are available in $1 increments (instead of $2.50 or $5.00 increments).  Otherwise, the difference between the premium you are buying vs the premium you are selling is too much.
• The DC appears to generally outperform the DD assuming the pre-earnings stock moves are not too much and are not big spikes in short time-frames/overnight that don't give you time to adjust your trade.
• The DD does offer protection for earnings leaks or early announcements coupled with the corresponding large IV drop.  For example, if PCLN earnings came out early and the same stock move occurred then the DC would basically be worthless (100% loss) but the DD would still be worth approx the difference in the strikes $5.00 in this case (32% loss).

Edited August 9, 2013 by Yowster