Can We Profit From Volatility Expansion Into Earnings?
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By Kim
The study was done today - here is the link. The parameters of the study:
Use AAPL and GMCR as underlying. Buy a ATM straddle option 20 days before earnings. Sell it just before the announcement. The results of the study, based on 48 cycles (2009-2014)
AAPL P/L: -$2933 GMCR P/L: -$2070 Based on those results, they declared (once again) that buying a straddle before earnings is a losing strategy.
What's wrong with this study?
Dismissing the whole strategy based on two stocks is completely wrong. You could say that this strategy does not work for those two stocks. This would be a correct statement. Indeed, we do not use those two stocks for our straddles strategy. From our experience, entering 20 days before earnings is usually not the best time. On average, the ideal time to enter is around 5-10 days before earnings. This when the stocks experience the largest IV spike. But it is also different from stock to stock. The study does not account for gamma scalping. Which means that if the stock moves, you can adjust the strikes of the straddle or buy/sell stock against it. Many times the stock would move back and forward from the strike, allowing you to adjust several times. In addition, the study is probably based on end of day prices, and from our experience, the end of day price on the last day is usually near the day lows, and you have a chance to sell at higher prices earlier. The study completely ignores the straddle prices. We always look at prices before entering and compare them to previous cycles. Entering the right stocks at the right time at the right prices is what gives this strategy an edge. Not selecting random stocks, random timing and ignoring the prices.
As a side note, presenting the results as dollar P/L on one contract trade is meaningless. GMCR is trading around $150 today, and pre-earnings straddle options cost is around $1,500. In 2009, the stock was around $30, and pre-earnings straddle cost was around $500. Would you agree that 10% gain (or loss) on $1,500 trade is different than 10% gain (or loss) on $500 trade? The only thing that matters is percentage P/L, not dollar P/L.
Presenting dollar P/L could potentially severely skew the study. For example, what if most of the winners were when the stock was at $30-50 but most of the losers when the stock was around $100-150?
Tom Sosnoff and Tony Battista conclude the "study" by saying that "if anybody tells you that you should be buying volatility into earnings, they really haven't done their homework. It really doesn't work".
At SteadyOptions, buying pre-earnings straddle options is one of our key strategies. Check out our performance page for full results. As you can see from our results, the strategy works very well for us. We don't do studies, we do live trading, and our results are based on hundreds real trades.
Of course the devil is in the details. There are many moving parts to this strategy:
When to enter? Which stocks to use? How to manage the position? When to take profits? And much more.
So we will let tastytrade to do their "studies", and we will continue trading the strategy and make money from it. After all, as one of our members said, someone has to be on the other side of our trades. Actually, I would like to thank tastytrade for continuing providing us fresh supply of sellers for our strategy!
If you want to learn more how to use it (and many other profitable strategies):
Start Your Free Trial
Related Articles:
How We Trade Straddle Option Strategy
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
Long Straddle: A Guaranteed Win?
How We Made 23% On QIHU Straddle In 4 Hours
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By Kim
As a reminder, a strangle involves buying calls and puts on the same stock with different strikes. Buying calls and puts with the same strike is called a long straddle. Strangles usually provide better leverage in case the stock moves significantly.
So let’s see how it works. First, you must identify stocks which have a history of big post-earnings moves. Some examples include AMZN, Netflix, Google, Priceline (PCLN), and others. Then you buy a strangle or a straddle a day or two before the earnings are announced. If the stock has a big move, you sell for a big profit.
The problem is you are not the only one knowing that earnings are coming. Everyone knows that those stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper.
Let’s examine a few test cases from the 2011 earnings cycle.
AKAM announced earnings on Oct. 26. The $24 straddle could be purchased for $4.08. IV was 84%. The next day the stock jumped 15%, yet the straddle was worth only $3.81. The reason? IV collapsed to 47%. The market “expected” the stock to move 17-18%, based on previous moves, but the stock moved “only” 15% and the straddle lost 7%. BIDU announced earnings on Oct. 26. The stock moved 4.5% following the earnings. You could purchase the straddle at $19.55 the day before earnings. The same straddle was worth $13.47 the next day. That’s a loss of 31%. TIVO moved 2%, the straddle lost 29%. FSLR moved 3%, the straddle lost 55%. Now let’s check a couple of good trades.
NFLX announced earnings on October 24. The stock collapsed 34.9% the next day, a move of historical proportions. The 120 strangle could be purchased the day before earnings at $24.52 and sold the next day at $43.00. That’s a 75% gain, but this is as good as it gets. This is a move of historic proportions but the trade is even not a double. AMZN straddle gained 57%. CME straddle gained 62%. GMCR straddle gained 84%. It is easy to get excited after a few trades like NFLX, GMCR, CME and AMZN. However, we have to remember that those stocks experienced much larger moves than their average move in the last few cycles. In some cases, the move was double what was expected. NFLX and GMCR moved more than 35%, the largest moves in at least 10 years. Chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit.
Some people might argue that if the trade is not profitable the same day, you can continue holding or selling only the winning side till the stock moves in the right direction. It can work under certain conditions. For example, if you followed the specific stock in the last few cycles and noticed some patterns, such as the stock continuously moving in the same direction for a few days after beating the estimates. Another example is holding the calls when the general market is in uptrend (or downtrend for the puts).
However, it has nothing to do with the original strategy. From the minute you decide to hold that trade, you are no longer using the original strategy. If the stock didn’t move enough to generate a profit, you must be ready to make a judgement call by selling one side and taking a directional bet. This might work for some people, but the pure performance of the strategy can be measured only by looking at a one day change of the strangle or the straddle (buying a day before earnings, selling the next day).
The bottom line:
Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.
Jeff Augen, a successful options trader and author of six books, agrees:
It doesn’t necessarily mean that the strategy cannot work and produce great results. However, in most cases, you should be prepared to hold beyond the earnings day, in which case the performance will be impacted by many other factors, such as your trading skills, general market conditions etc.
To hedge your bets and reduce the loss if the stock doesn't move, you might consider trading a Reverse Iron Condor.
This article was originally published here.
Related articles:
How We Trade Straddle Option Strategy Exploiting Earnings Associated Rising Volatility Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? Long Straddle: A Guaranteed Win? Straddle, Strangle Or Reverse Iron Condor (RIC)? How We Made 23% On QIHU Straddle In 4 Hours Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings How To Calculate ROI On Credit Spreads Straddle Option Overview Long Straddle Through Earnings Backtest Straddles - Risks Determine When They Are Best Used The Gut Strangle Long And Short Straddles: Opposite Structures -
By Stephan Haller
But with undefined risk strategies comes theoretical unlimited risk. Therefore it is crucial that you follow the rules I pointed out in my books and which are mentioned about almost every day on tastytrade
Rules:
do not use more than 40 - 50% of your available capital on your overall portfolio do not use more leverage than 3x notional of your net liq (if you have a $100k account, don't go over $300k notional) manage at 21 DTE to avoid gamma risk manage your strangles at 50% of max profit and your straddles at 25% of max profit. spread your risk among lots of uncorrelated underlyings commit capital based on IVR or the VIX (high VIX risk up to 50% on your overall portfolio, if VIX is low, risk less) Now let's have a look at what you can expect in profit if you sell different type of strangles/straddles:
16 Delta Short Strangles:
tastytrade has shown in a study that you can expect to keep 25% of the daily theta if you sell 16 delta short strangles in SPY, IWM and TLT.
Image source: tastytrade
Let's have a look at how much contracts you could sell, until you exceed 50% of your capital in margin requirement and/or 3x notional leverage and how much money you would make in a full year.
For the study I was using August 13th 2019 closing prices. Although the percentage of theta you can expect to keep is higher than 25% in SPY and IWM, I was using the 25% number, to be more conservative.
SPY 16 Delta Strangles
As you can see, if you just sell 16 delta short strangles in SPY, you can expect to make 9.11% in profit, if you go up to 3x notional leverage.
IWM 16 Delta Short Strangles
As you can see, if you just sell 16 delta short strangles in IWM, you can expect to make 10.93% in profit, if you commit 50% of your buying power.
Now let's have a look at short straddles.
tastytrade has shown in a study that you can expect to keep 40-50 % of the daily theta if you sell atm short straddles in SPY.
Image source: tastytrade
Let's have a look at how much contracts you could sell, until you exceed 50% of your capital in margin requirement and/or 3x notional leverage and how much money you would make in a full year.
For the study I was using August 13th 2019 closing prices.
For the daily theta you can expect to keep, I was using 45% as the tastytrade suggested.
SPY Short Straddles
As you can see, if you just sell atm short straddles in SPY, you can expect to make 18.13% in profit, if you commit 46.83% of your buying power.
IWM Short Straddles
As you can see, if you just sell atm short straddles in SPY, you can expect to make 25.25% in profit, if you commit 48.12% of your buying power.
Since we want to diversify our portfolio, let's have a look at the 5 most uncorrelated underlyings, which I showed in my first book.
For these examples I was using today's (August 14 2019) prices right at the open.
GLD Short Straddles
TLT Short Straddles
FXE Short Straddles
IWM Short Straddles
XLE Short Straddles
In the next article I will show you how to build a portfolio with these five underlyings and how to commit your capital based on the VIX, so that you don't get wiped out in a move we experience at the moment.
Stephan Haller is an author, teacher, options trader and public speaker with over 20 years of experience in the financial markets. Check out his trilogy on options trading here. This article is used here with permission and originally appeared here.
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By Kim
Who Was Karen the Supertrader?
Karen Bruton, known better as Karen the Supertrader, is a former hedge fund manager who became famous after multiple appearances on the Tastytrade live show.
Bruton started as a novice retail trader who knew virtually nothing about trading and became a multimillionaire in a handful of years. Specifically, she turned $110,000 into $41 million between 2008 and 2011 using basic option selling strategies.
Following her massive personal trading success, Karen started a hedge fund called Hope Advisors.
Nowadays, Karen the Supertrader is infamous because she was barred from managing outside money by the SEC. According to the SEC’s complaint, Bruton was continually rolling losing positions forward to avoid realizing a loss and thus, in the eyes of the SEC, misleading investors.
Because selling options results in immediate income, it’s been the weapon of choice for traders who are hiding large losses. Nick Leeson, a rogue trader who famously brought down Barings Bank, also hid his losses by selling naked options.
What Was Karen the Supertrader’s Strategy?
Karen the Supertrader’s trading strategy, sometimes referred to as the “KST method,” was based on the concept of theta decay. Her approach involved short selling options with the expectations that they would become worthless upon expiration.
By focusing on options that were highly likely to expire out-of-the-money, Karen leveraged the gradual erosion of their time value to her advantage.
Karen focused primarily on equity index options on the S&P 500, Nasdaq 100, and Russell 2000. Focusing on a small number of highly liquid symbols allowed her to form a consistent strategy.
Her strategy involved selling options that were two standard deviations out-of-the-money with expiration dates ranging between 30 and 56 days to expiration. In other words, these options were roughly 95% likely to expire worthless.
As far as systematically selling options goes, Karen’s strategy is par for the course. Most traders who use a similar strategy tend to sell deep out-of-the-money (OTM) options, as they will expire worthless most of the time. The strategy tends to rack up several consecutive winning trades that are relatively small in size with a rare losing trade that will be significantly larger.
Karen the Supertrader Trading Rules
Let’s take a more granular look at the specific trading rules that Karen the Supertrader has publicly reported using.
Firstly, she preferred a short strangle trade structure. This gave her a market neutral market outlook, taking no position on which direction the market will move next. Her only goal with the trade was for the market to remain inside her chosen strikes until expiration or until she closed the trade.
Here’s an example of what a short strangle looks like:
When it comes to short strangle strike selection, Karen the Supertrader used Bollinger Bands to select her strikes. Bollinger Bands are a technical indicator that plots trading bands two standard deviations away from a moving average.
See the chart below for an example:
She primarily traded in expiration dates ranging from 25 days to 56 days at the latest.
To round up all of these rules, let’s create a rough example of an SPX short strangle trade that Karen the Supertrader might take, based on the rules she’s reported publicly in her Tastytrade interviews:
● Trade type: short strangle
● Put strike: 3875
● Call strike: 4230
● Expiration date: June 23 (39 days to expiration)
Karen would typically take profits on winning trades, and roll out losing trades to a later expiration.
Today she manages 190 million dollars, after making nearly 105 million in profits.
Before we start analyzing Karen the Supertrader's strategy, lets be clear: she did NOT make 105 million in profits as TastyTrade claims. That number includes money from new investors. This headline is misleading at best, deception at worst.
How much did she really make? We don't really know, but lets try to "guess".
With SPX currently at 2075, she would sell May 1825 puts and 2280 calls. This is how the P/L chart would look:
So she would get around $700 credit on ~21k in margin. If she holds till expiration and both options expire worthless, the trade produces 3.5% gain in 59 days. That's 21% annualized gain on 50% capital, or ~11% gain on the whole account.
This assumes that both options expire worthless and no adjustment is needed. This also assumes regular margin. With her capital, she obviously gets portfolio margin, so her margin requirements are significantly less. But if she wants to take advantage of portfolio margin, she has to sell more contracts, taking much more risk. For the sake of her investors, I hope she is using 50% of the regular margin, not portfolio margin.
In any case, I have hard time to see how she can make more than 25-30%/year with this strategy. Don't get me wrong, this is an excellent return - however, by selling naked options, she also takes a LOT of risk. To make 25-30%/year with this strategy, she must use a lot of portfolio margin - which means a lot of leverage. Karen the Supertrader’s strategy is also short gamma and short vega, which means as the market moves against her, the positions become worse at a greater rate. If volatility spikes like it did in 2008, her account will be gone in matter of days.
Here are some questions/comments taken from public discussions about Karen SuperTrader:
I really have no idea how that is possible. In the TOS platform, if I sell a naked Put, the usual margin required is very large. We’re talking that my short Put usually would yield between 1.5% – 2.5% of the margin required. - I think there is more than a fair chance she may be a fraud and possibly even an invention of TastyTrade. Any manager worth her salt would be happy to provide audited returns, especially if only managing 150 million. She is probably generating around 30% a year while taking a lot of risk. I don’t know if that makes sense in the long run. Another thing that’s strange is the fact there’s not even one chart or table of her performance. I hear a lot of big numbers but just give the facts black on white. This strategy will only work for a period of time. When it stops, the results will be catastrophic. If she was that good as she claims she is, after 7 years of such spectacular returns she would have few billion under management, not 190 million. It’s Finance 101 isn’t it? The higher the return, the higher the risk you have to take. If she is generating 30% or greater per year, she is taking on a lot of risk. Hopefully her investors realize that.
Here are some articles about Karen SuperTrader:
http://www.optionstradingiq.com/karen-the-supertrader/
http://smoothprofit.blogspot.ca/2012/11/a-glimpse-of-option-strategies-of-karen.html
So: IS Karen SuperTrader myth or reality? You decide.
June 2016 update:
Karen is now being investigated by the SEC for fraud. Don't say we didn't warn you.
Read my latest article: Karen Supertrader: Too Good To Be True?
Here are the links to the SEC claim and the verdict:
https://www.sec.gov/news/pressrelease/2016-98.html
https://www.sec.gov/alj/aljdec/2019/id1386cff.pdf
I suspect that investors will not learn the lesson from this case. Humans desperately want to believe there is a way to make money with no or little risk. That’s why Bernie Madoff existed, and it will never change.
TastyTrade removed all articles and videos related to Karen the Supertrader from their website and YouTube right after the SEC investigation started, but returned them few days afterwards.
Karen the Supertrader: Where Is She In 2023?
The SEC sued Karen the Supertrader’s hedge fund, Hope Advisors, leading to the hedge fund paying a hefty fine, disgorging of profits, and Karen Bruton’s ban from managing outside money.
However, Karen still appears in interviews, like she did with Michael Sartain in 2022. She maintains that the SEC unfairly targeted her firm seeking an easy prosecution. Both Karen and Michael Sartain, the host of the podcast, claim that the SEC’s complaint took issue with the fact that Karen’s hedge fund rolled losing positions forward, a common practice among systematic premium sellers.
Her point of view is that the SEC interpreted the fund rolling its losing positions forward as the act of a rogue trader, rather than the routine actions of an options trader who sells premium.
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By Kim
However, not all stocks are suitable for that strategy. Some stocks experience consistent pattern of losses when buying premium before earnings. For those stocks we are using some alternative strategies like calendars.
In one of my previous articles I described a study done by tastytrade, claiming that buying premium before earnings does not work. Let's leave aside the fact that the study was severely flawed and skewed by buying "future ATM straddle" which simply doesn't make sense (see the article for full details). Today I want to talk about the stocks they used in the study: TSLA, LNKD, NFLX, AAPL, GOOG.
Those stocks are among the worst candidates for a straddle option strategy. In fact, they are so bad that they became our best candidates for a calendar spread strategy (which is basically the opposite of a straddle strategy). Here are our results from trading those stocks in the recent cycles:
TSLA: +28%, +31%, +37%, +26%, +26%, +23% LNKD: +30%, +5%, +40%, +33% NFLX: +10%, +20%, +30%, +16%, +30%, +32%, +18% GOOG: +33%, +33%, +50%, -7%, +26%
You read this right: 21 winners, only one small loser.
This cycle was no exception: all four trades were winners, with average gain of 25.2%.
I'm not sure if tastytrade used those stocks on purpose to reach the conclusion they wanted to reach, but the fact remains. To do a reliable study, it is not enough to take a random list of stocks and reach a conclusion that a strategy doesn't work.
At SteadyOptions we spend hundreds of hours of backtesting to find the best parameters for our trades:
Which strategy is suitable for which stocks? When is the optimal time to enter? How to manage the position? When to take profits?
The results speak for themselves. We booked 147% ROI in 2014 and 32% ROI so far in 2015. All results are based on real trades, not some kind of hypothetical or backtested random study.
Related Articles:
How We Trade Straddle Option Strategy
How We Trade Calendar Spreads
Buying Premium Prior to Earnings
Can We Profit From Volatility Expansion into Earnings
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
The Less Risky Way To Trade TSLA
If you want to learn more how to use our profitable strategies and increase your odds:
Start Your Free Trial
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By Ophir Gottlieb
That's great, because it means there is discord, and discord, especially for Apple ahead of earnings has meant a repeating pattern for the clever trader to take advantage of.
One week before Apple's earnings would be January 25th, 2018.
Apple's Disagreement
Sometimes a bullish momentum bet works great -- and in fact, for Apple that has been a strong pattern ahead of earnings. But with a toppy market, sometimes a different approach can work as well.
It turns out, over the long-run, for stocks with certain tendencies like Apple Inc, there is a clever way to trade market anxiety or market optimism before earnings announcements with options.
This approach has returned 189% with 10 wins and 2 losses over the last 3-years.
The Trade Before Earnings
What a trader wants to do is to see the results of buying a slightly out of the money strangle one-week before earnings, and then sell that strangle just before earnings.
Here is the setup:
We are testing opening the position 7 calendar days before earnings and then closing the position 1 day before earnings. This is not making any earnings bet. This is not making any stock direction bet.
Once we apply that simple rule to our back-test, we run it on a 40-delta strangle, which is a fancy of saying, buying both the 40-delta call and 40-delta put, for a non-directional bet on volatility.
Returns
If we did this long strangle in Apple Inc (NASDAQ:AAPL) over the last three-years, but only held it before earnings, using the options closest to 14 days from expiration, we get these results:
AAPL
Long 40 Delta Strangle % Wins: 83.3% Wins: 10 Losses: 2 % Return: 189%
Tap Here to See the Back-test
The mechanics of the TradeMachine™ are that it uses end of day prices for every back-test entry and exit (every trigger).
We see a 189% return, testing this over the last 12 earnings dates in Apple Inc.
We can also see that this strategy hasn't been a winner all the time, rather it has won 10 times and lost 2 times, for a 83.3% win-rate on an one-week trade.
Setting Expectations
While this strategy has an overall return of 189%, the trade details keep us in bounds with expectations:
➡ The average percent return per trade was 16.9% over 7-days.
➡ The average percent return per winning trade was 21.8% over 7-days.
➡ The average percent return per losing trade was -7.6% over 7-days.
We like the comfort of a trade that, when it loses, it isn't a disaster -- at least not historically.
Option Trading in the Last Year
We can also look at the last year of earnings releases and examine the results:
AAPL
Long 40 Delta Strangle % Wins: 100% Wins: 4 Losses: 0 % Return: 98.2%
Tap Here to See the Back-test
In the latest year this pre-earnings option trade has 4 wins and lost 0 times and returned 98.2%.
➡ Over just the last year, the average percent return per trade was 22.3% over 7-days.
WHAT HAPPENED
We don't always have to look at bullish back-tests in a bull market -- sometimes a straight down the middle volatility pattern pops up. This is it -- this is how people profit from the option market -- finding trading opportunities that avoid earnings risk and work equally well during a bull or bear market.
To see how to do this for any stock we welcome you to watch this quick demonstration video:
Tap Here to See the Tools at Work
Risk Disclosure
You should read the Characteristics and Risks of Standardized Options.
Past performance is not an indication of future results.
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By Stephan Haller
Lately we experienced a 7% down move in the S&P 500.
image source: TOS trading platform
We have also seen an explosion in the VIX.
image source: TOS trading platform
All in all a pretty shitty situation if you have a delta neutral short premium portfolio.
So let's have a look how a portfolio consisting of 30 delta short strangles and/or atm short straddles in IWM, FXE, TLT, GLD, XLE, which was started before this wild ride in the markets happened, would have performed.
Set up
As shown in my books, IWM, FXE, TLT, GLD, XLE are the most uncorrelated ETFs. With these underlyings you have exposure to the Russell 2000, the Euro Currency, Bonds, Gold and the Oil Sector.
Rules
$100k portfolio capital allocation based on the VIX (20-25% allocation in very low VIX environment, 40-50% in a high VIX environment) equal buying power in all underlyings never go above 3x leverage in notional value 30 delta short strangles or atm straddles about 45 DTE profit target = 16 delta strangle credit at trade entry close all positions at 21 DTE if profit target is not hit before if short strike in strangles gets hit, roll untested side into a short straddle (original profit target doesn't change) if break even in a short straddle gets hit, roll untested side to the new atm strike (going inverted) if IVR in IWM goes above 50% and/or VIX makes a big up move, add aggressive short delta strangle to balance deltas
Portfolio Performance
As a starting date I picked July 30th 2019, probably the worst day in this expiration cycle to start this kind of portfolio. Since the VIX and IVR was pretty low at this moment, I committed only a little bit above 25% of my net liq.
IWM
image source: TOS trading platform
FXE
image source: TOS trading platform
TLT
image source: TOS trading platform
GLD
image source: TOS trading platform
XLE
image source: TOS trading platform
Portfolio
So far in dollar terms a $1,571.50 loss or 1.571% loss on the whole portfolio.
Not too bad considering the IV explosion and the big moves, especially in TLT.
As you can see, even in a tough market with big outside the expected moves and IV explosion, short strangles/straddles are not a recipe for disaster.
The key is to trade small when IV is low and mechanically adjust your positions/deltas.
Of course the expiration cycle is not over yet and we can still have more big moves and much higher implied volatility in the coming days, but you should have seen now, when you have the right set of rules and religiously stick to these rules and when you trade small enough when IV is low, you are not going to blow up your portfolio.
Stephan Haller is an author, teacher, options trader and public speaker with over 20 years of experience in the financial markets. Check out his trilogy on options trading here. This article is used here with permission and originally appeared here.
Related articles
Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work? James Cordier: Another Options Selling Firm Goes Bust How Victor Niederhoffer Blew Up - Twice
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By Kim
About six months ago, I came across an excellent book by Jeff Augen, “The Volatility Edge in Options Trading”. One of the strategies described in the book is called “Exploiting Earnings - Associated Rising Volatility”. Here is how it works:
Find a stock with a history of big post-earnings moves. Buy a strangle for this stock about 7-14 days before earnings. Sell just before the earnings are announced. For those not familiar with the strangle strategy, it involves buying calls and puts on the same stock with different strikes. If you want the trade to be neutral and not directional, you structure the trade in a way that calls and puts are the same distance from the underlying price. For example, with Amazon (NASDAQ:AMZN) trading at $190, you could buy $200 calls and $180 puts.
IV (Implied Volatility) usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes.
Like every strategy, the devil is in details. The following questions need to be answered:
Which stocks should be used? I tend to trade stocks with post-earnings moves of at least 5-7% in the last four earnings cycles; the larger the move the better. When to buy? IV starts to rise as early as three weeks before earnings for some stocks and just a few days before earnings for others. Buy too early and negative theta will kill the trade. Buy too late and you might miss the big portion of the IV increase. I found that 5-7 days usually works the best. Which strikes to buy? If you go far OTM (Out of The Money), you get big gains if the stock moves before earnings. But if the stock doesn’t move, closer to the money strikes might be a better choice. Since I don’t know in advance if the stock will move, I found deltas in the 20-30 range to be a good compromise. The selection of the stocks is very important to the success of the strategy. The following simple steps will help with the selection:
Click here. Filter stocks with movement greater than 5% in the last 3 earnings. For each stock in the list, check if the options are liquid enough. Using those simple steps, I compiled a list of almost 100 stocks which fit the criteria. Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Netflix (NASDAQ:NFLX), F5 Networks (NASDAQ:FFIV), Priceline (PCLN), Amazon (AMZN), First Solar (NASDAQ:FSLR), Green Mountain Coffee Roasters (NASDAQ:GMCR), Akamai Technologies (NASDAQ:AKAM), Intuitive Surgical (NASDAQ:ISRG), Saleforce (NYSE:CRM), Wynn Resorts (NASDAQ:WYNN), Baidu (NASDAQ:BIDU) are among the best candidates for this strategy. Those stocks usually experience the largest pre-earnings IV spikes.
So I started using this strategy in July. The results so far are promising. Average gains have been around 10-12% per trade, with an average holding period of 5-7 days. That might not sound like much, but consider this: you can make about 20 such trades per month. If you allocate just 5% per trade, you earn 20*10%*0.05=10% return per month on the whole account while risking only 25-30% (5-6 trades open at any given time). Does it look better now?
Under normal conditions, a strangle trade requires a big and quick move in the underlying. If the move doesn’t happen, the negative theta will kill the trade. In case of the pre-earnings strangle, the negative theta is neutralized, at least partially, by increasing IV. In some cases, the theta is larger than the IV increase and the trade is a loser. However, the losses in most cases are relatively small. Typical loss is around 10-15%, in some rare cases it might reach 25-30%. But the winners far outpace the losers and the strategy is overall profitable.
Market environment also plays a role in the strategy performance. The strategy performs the best in a volatile environment when stocks move a lot. If none of the stocks move, most of the trades would be around breakeven or small losers. Fortunately, over time, stocks do move. In fact, big chunk of the gains come from stock movement and not IV increases. The IV increase just helps the trade not to lose in case the stock doesn’t move.
In the next article I will explain why, in my opinion, it usually doesn’t pay to hold through earnings. We always close those trade before earnings to avoid IV crush.
The original article was published here.
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By Kim
Here is how their methodology works:
In theory, if you knew exactly what price a stock would be immediately before earnings, you could purchase the corresponding straddle a number of days beforehand. To test this, we looked at the past 4 earnings cycles in 5 different stocks. We recorded the closing price of each stock immediately before the earnings announcement. We then went back 14 days and purchased the straddle using the strikes recorded on the close prior to earnings. We closed those positions immediately before earnings were to be reported.
Study Parameters:
TSLA, LNKD, NFLX, AAPL, GOOG Past 4 earnings cycles 14 days prior to earnings - purchased future ATM straddle Sold positions on the close before earnings
The results:
Future ATM straddle produced average ROC of -19%.
As an example:
In the previous cycle, TSLA was trading around $219 two weeks before earnings. The stock closed around $201 a day before earnings. According to tastytrade methodology, they would buy the 200 straddle 2 weeks before earnings. They claim that this is the best case scenario for buying pre-earnings straddles.
My Rebuttal
Wait a minute.. This is a straddle, not a calendar. For a calendar, the stock has to trade as close to the strike as possible to realize the maximum gain. For a straddle, it's exactly the opposite:
When you buy a straddle, you want the stock to move away from your strike, not towards the strike. You LOSE the maximum amount of money if the stock moves to the strike.
In case of TSLA, if you wanted to trade pre-earnings straddle 2 weeks before earnings when the stock was at $219, you would purchase the 220 straddle, not 200 straddle. If you do that, you start delta neutral and have some gamma gains when the stock moves to $200. But if you start with 200 straddle, your initial setup is delta positive, while you know that the stock will move against you.
It still does not guarantee that the straddle will be profitable. You need to select the best timing (usually 5-7 days, not 14 days) and select the stocks carefully (some stocks are better candidates than others). But using tastytrade methodology would GUARANTEE that the strategy will lose money 90% of the time. It almost feels like they deliberately used those parameters to reach the conclusion they wanted.
As a side note, the five stocks they selected for the study are among the worst possible candidates for this strategy. It almost feels like they selected the worst possible parameters in terms of strike, timing and stocks, in order to reach the conclusion they wanted to reach.
At SteadyOptions, buying pre-earnings straddles is one of our key strategies. It works very well for us. Check out our performance page for full results. As you can see from our results, "Buying Premium Prior To Earnings" is still alive and kicking. Not exactly "Nail In The Coffin".
Comment: the segment has been removed from tastytrade website, which shows that they realized how absurd it was. We linked to the YouTube video which is still there.
Of course the devil is in the details. There are many moving parts to this strategy:
When to enter? Which stocks to use? How to manage the position? When to take profits?
And much more. But overall, this strategy has been working very well for us. If you want to learn more how to use it (and many other profitable strategies):
Subscribe to SteadyOptions now and experience the full power of options trading at your fingertips. Click the button below to get started!
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