tastytrade tried to Put The Nail In The Coffin On Buying Premium Prior To Earnings. They did it several times, and we debunked their studies several times.
Kirk Du Plessis from OptionAlpha conducted a comprehensive study backtesting different earnings strategies. This is the part that is relevant to our pre earnings straddle strategy:
The conclusion is that buying long straddle (or strangle) and closing the day before earnings is a losing proposition. The backtest included different entry days from earnings: 30, 20, 10, 5, or 1 day from the earnings event.
Our real life trading results are very different:
You can see full statistics here.
The question many people ask us: are all those studies wrong? How their results are so different from our real life trading performance?
The answer is that the studies are not necessarily wrong. They just have serous limitations, such as:
The studies use the whole universe of stocks, while we use only a handful of carefully selected stocks that show good results in backtesting.
The studies use certain randomly selected entry dates, while we enter only when appropriate.
The studies use EOD (End Of Day) prices while we take advantage of intraday price fluctuations.
The studies exit a day before earnings while we manage the trades actively by taking profits when our profit targets are hit. This makes a world of difference.
If you are not a member yet, you can join our forum discussions for answers to all your options questions.
Here is a classic example how real trading is different from "studies".
On March 2 2:30pm we entered CPB straddle:
The price was 3.05 or 6.5% RV. When considering a trade, we look at the straddle price as percentage of the stock price. We call it RV (Relative Value). We based our entry on the CPB RV chart:
We exited the trade on March 3 10:05am for $3.45 credit, 13.1% gain
EOD price on March 2 was 3.40 and EOD price on March 3 was 2.95. The study using EOD prices would show 13.2% LOSS while our real trade was closed for 13.1% GAIN.
Two points that contributed to the difference:
We have a very strict criteria for entering those trades. In some cases we might wait weeks for the price to come down and meet our criteria. Based on historical RV charts, we would not even be entering this trade at 3.40.
On the last day, we did not wait till the EOD and closed the trade in the morning when it reached our profit target. This is just one example how a "study" can show dramatically different results from real trading.
On a related note, using a dollar P/L in a study is meaningless - this alone disqualifies the whole study. The only thing that matter is percentage amount. Why? Because in order to get objective results, you need to apply the same dollar allocation to all trades.
For example, lets take a look on stocks like AMZN and GM. AMZN straddle can cost around $200 and GM straddle around $2. If AMZN straddle average return was -10% or -$20 and GM average return was +50% or $1, the average return should be reported as +20%. In the study, it would be reported as -$9.5.
Don't believe everything you read. Use your common sense and take everything with a grain of salt.
I have a great respect for Kirk. He is one of the most honest, professional and hardworking people in our industry, but even the greatest minds sometimes get it wrong.
How We Trade Straddle Option Strategy Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? How We Made 23% On QIHU Straddle In 4 Hours Why We Sell Our Straddles Before Earnings
Trade Explanation: For the Volatility Advisory in NFLX, we are selling the Apr 427.5 puts and 520 calls and buy the Apr 425 puts and 522.5 calls for a net credit of $0.91 to open.
Underlying Price: $474.22
Price Action: We are selling this $2.5-wide Iron Condor in the online streaming company for a credit of $0.91. For an Iron Condor trade, we sell an out-of-the-money Call Vertical (520/522.5) and Put Vertical (427.5/425) simultaneously. The company has earnings after the close and the option markets are pricing in a move of 8-9%. We expect the shares to move after the report but are giving ourselves a nice range of $92.5 between the short strikes. We need the shares to continue to trade between our break-even levels of $426.59 on the downside and $520.91 on the upside.
The following was described as a rationale for the trade:
Volatility: Volatility is elevated in the Apr options which makes this trade attractive. The IV percentile rank is elevated at 73% also which also gives us a good opportunity to sell this Iron Condor. We expect volatility to fall sharply after earnings which will contract the value of this short-term neutral position.
Probability: There is an 80% probability that NFLX shares will be below the $520 level and a 80% probability that it will be above the $427.5 level at Apr expiration. This trade offers a good Risk/Reward scenario with the amount of credit collected vs. the probability numbers for this position.
Trade Duration: We have 2 days to Apr expiration in this position. This is a short-term position and time decay will increase quickly due to the time frame and the earnings report.
Logic: We want to take advantage of the increased volatility in our option by initiating this earnings play. Our short verticals are outside of the anticipated one standard deviation move that the options are pricing in so our probabilities are positive. The shares will hopefully remain between our short verticals and we will be aggressive in closing the trade.
It is true that Volatility is elevated in the Apr options, but this is completely normal, considering the upcoming earnings and does NOT make the trade attractive.
It is also true that volatility will fall sharply after earnings, but it is not relevant if the stock will be trading above the long strikes. In this case, the trade will still lose 100%.
2 days to Apr expiration makes the trade much more risky because there will be no time to adjust or take any corrective action.
"80% probability that NFLX shares will be below the $520 level" means nothing when earnings are involved. The price action will be determined by earnings only, not by options probabilities.
"The shares will hopefully remain between our short verticals" - hope is not a strategy.
The short strikes are less than 10% from the stock price, which is not far enough, considering NFLX earnings history.
Now, I want you to take a look at the last 10 cycles of NFLX post-earnings moves:
(This screenshot is taken from OptionSlam.com).
Now, I'm asking you this:
WHO IN HIS RIGHT MIND WOULD TRADE AN IRON CONDOR WITH SHORT STRIKES LESS THAN 10% FROM THE STOCK, ON A STOCK THAT HAS TENDENCY TO MOVE 15-25% AFTER EARNINGS ON A REGULAR BASIS???
The stock is trading above $530 after hours. If it stays this way tomorrow, this trade will be a 100% loser, and there is NOTHING you can do about it. But frankly, the final result doesn't really matter. To me, this trade is simply insane and shows complete lack of basic options understanding.
That said, I'm not completely dismissing trading Iron Condors through earnings. For many stocks, options consistently overestimate the expected move, and for those stocks, this strategy might have an edge (assuming proper position sizing). But NFLX is one of the worst stocks to use for this strategy, considering its earnings history.
Watch the video:
If you want to learn how to trade earnings the right way (we just booked 30% gain in NFLX pre-earnings trade):
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The first question you need to answer is: will you hold your position through earnings, or will you close it before the announcement.
In some of my previous articles, I described few ways to trade earnings if you don't want to hold the trade through the announcement. Our favorite ways to do it are with Straddles and Calendar Spreads. Personally I don't like to hold those trades through earnings. But if you decide to do so, please make sure you do it the proper way and understand the risks.
So if you decided to hold, the next questions would be: directional or non directional? Buy premium or sell premium?
Here is a simple way to look at potential trades. The options market will always tell you how much stock movement the options market is pricing in for earnings, or any event.
For example, let’s take a look at what the options market was expecting from Apple (AAPL), which reported earnings last month.
With AAPL stock trading at 190 we need to look at the price of the straddle closest to 190. And these options need to be the calls and puts that expire the week of earnings.
In this case, with earnings on July 31, we look for the options that expire on Friday, August 3. The calls were worth approximately $4.85, and the puts were worth $4.27 just before earnings were announced. When we combine these two values it tells us that the options market is pricing in an expected move of $9.12, or 4.8%, after earnings. This is what we call the "implied move".
Now you need to do some homework and decide if you believe the options are overpriced (and the stock will move less than the implied move) or underpriced (and the stock will move more than the implied move).
If you believe that the options are underpriced, you should buy premium, using a long straddle or a long strangle.
If you buy a straddle, then the P/L is pretty much straightforward:
If the stock moves more than the implied move after earnings, your trade will be a winner. If the stock moves less than the implied move after earnings, your trade will be a loser. Taking AAPL earnings as an example:
The straddle implied $9.12 or 4.8% move. In reality the stock moved almost $12, or ~6.0%. Which means that the straddle return was over 25%.
Strangle is a more aggressive strategy. It would usually require the stock to move more to produce a gain. But if the stock cooperates, the gains will be higher as well. In case of AAPL, doing 185/195 strange would produce over 40% gain (all prices are at the market close before and after earnings).
Obviously if the stock did not cooperate, the strangle would lose more as well. Which makes it a higher risk higher reward trade.
If you believe that the options are overderpriced, you should sell premium. You can sell premium in one of the following ways:
Sell a (naked) straddle. This strategy is the opposite of buying a long straddle, and the results will be obviously opposite as well. If the stock moves more than expected, the trade will be a loser. If it moves less than expected, it will be a winner.
Sell a (naked) strangle. This strategy is an opposite of buying a long strangle, and similarly, a more aggressive trade. Take the last FB earnings for example. Selling 1 SD strangle would produce a $208 credit. When the stock was down almost 20% after earnings, the trade was down a whopping $2,407, which would erase 12 months of gains (even if ALL previous trades were winners). This is why I would recommend never holding naked options positions through earnings. The risk is just too high.
Buy an iron condor. This strategy would involve selling a strangle and limiting the risk by buying further OTM strangle. In case of a big move, your loss is at least limited. Selling options around 1 SD would produce modest gains most of the time, but average loss will typically be few times higher than average gain.
Buy a butterfly spread. This strategy would involve selling a straddle and limiting the risk by buying a strangle. In case of a big move, your loss is at least limited, like with iron condor. This strategy has much more favorable risk/reward than iron condor, but number of losing trades will be much higher as well.
Buy a calendar spread. This strategy would involve selling ATM put or call expiring on the week of earnings and buying ATM put or call with further expiration. The rationale is that near term short options will experience much bigger IV collapse than the long options, making the trade a winner. To me, this would probably be the best way to hold through earnings in terms of risk/reward and limiting the losses. As a rule of thumb:
If the stock moves as expected after earnings, all strategies will be around breakeven. If the stock moves more than expected after earnings, all premium buying strategies will be winners, and all premium selling strategies will be losers. So which one is better?
To me, any strategy that involves holding through earnings is just slightly better than 50/50 gamble (assuming you did your homework and believe that you have an edge). Earnings are completely unpredictable. Selling options around earnings have an edge on average for most stocks, but they have a much higher risk than buying options, especially if the options are uncovered. Those "one in a lifetime events" like Facebook 20% drop happen more often than you believe.
Many options "gurus" recommend selling premium before earnings to take advantage of Implied Volatility collapse that happens after earnings. What they "forget" to mention is the fact that if the stock makes a huge move, IV collapse will not be very helpful. The trade will be a big loser regardless.
Directional or non directional?
So far we discussed non directional earnings trades, where you select ATM options. But those trades can be structured with directional bias as well. For example:
If you were bullish before AAPL earnings and believed the stock will go higher, instead of buying the 190 straddle, you could buy the 185 straddle. This trade would be bullish, and earn more if the stock moved higher, but it would also lose more than ATM straddle if you were wrong and the stock moved down. As an alternative, you could buy an OTM calendar (for example, at $200 strike). If you were right, you would benefit twice: from the stock direction and IV collapse. But you would need to "guess" the price where you believe the stock will be trading after earnings with high level of accuracy. If you guess the direction right, but the stock makes huge move beyond the calendar strike, you can still lose money even if you were right about the direction.
For example, the 190 (ATM) calendar would lose around 40-50% (which was expected since the stock moved more than the implied move). But the 200 (OTM) calendar would gain around 120% since the stock moved pretty close to the 200 strike, so you gained from the IV collapse AND the stock movement.
Earnings trades are high risk high reward trades if held through earnings. Anything can happen after earnings, so you should always assume 100% loss and use a proper position sizing. Traders who advocate those strategies argue that they can always control risk with position sizing, which is true.
But the question is: if I can trade safer strategies and allocate 10% per trade, why trade those high risk strategies and allocate only 2% per trade? After all, what matters if the total portfolio return. If a trade which is closed before earnings earns 20% (with 10% allocation), it contributes 2% growth to the portfolio. To get the same portfolio return on a trade with 2% allocation, it has to earn 100%.
Is it worth the risk and the stress? That's for you to decide.
How We Trade Straddle Option Strategy Buying Premium Prior To Earnings - Does It Work? Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings How We Trade Calendar Spreads Long Straddle Through Earnings Backtest
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.
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
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.
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):
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How We Trade Straddle Option Strategy
Can We Profit From Volatility Expansion into Earnings
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
By Jeff - EarningsViz
I would like to introduce earningsviz.com, an options website focused on earnings trades. The thesis behind the website is simple: tail-end risk is mispriced around earnings events; by creating a simple and easy way to visualize this mispricing via analyzing option prices, it allows traders to pick the best strike prices and strategies to enter an earnings trade.
This is achieved by comparing a historical distribution of changes in the stock after earnings against the implied moves of the stock calculated via tight vertical spreads. This comparison yields an edge value that demonstrates whether a stock is fairy valued, or more favorable for option buyers/sellers. A more detailed explanation of the methodology can be found here.
Currently, EarningsViz is in a beta mode so all the information is available for free - the companies listed are all reporting next week (updated every Thursday/Friday). In the future, there will be a subscription required for accessing the information, and I plan on giving SteadyOptions users a discount.
Also, I plan on adding strategies and trades for pre and post earnings soon.
I am open to feedback/questions on the site as well as features you would like to see added, so let me know what you think!
By Jacob Mintz
(My full options education article on why buy-writes have the exact same risk/reward as selling naked puts is at the end of this article.)
The second reason I closed the position was there was a chance that SE would report earnings during the May expiration cycle. That would potentially bring another layer of risk to our May buy-write position. As you can see in the graphic below my options trading tool is estimating earnings will be reported the Wednesday before expiration, which would certainly keep the value of the buy-write high through earnings.
Another way I can determine when a company is due to report earnings is by comparing the volatility of the options each month. The volatility/price of options in the reporting month is higher than the months before and after earnings. Here is an example using Zendesk (ZEN), which will report earnings tonight:
What you can see in this graphic is that with the options expiring May 17 option volatility is 56.17, way more expensive than the June 21 option volatility, which is 41.77. In essence, the price of options/volatility is telling you that ZEN’s earnings are in the May option expiration.
Now let’s circle back to SE. Yesterday, the May option volatility in SE was significantly more expensive than June. And because of that I assumed that SE would report earnings in May.
However, based on a trade today, and how the options market is reacting to this trade, I now believe that SE’s earnings will come during the June expiration cycle, not May. First, here is the trade:
Seller of 7,500 Sea (SE) May 25 Calls for $1 – Stock at 25
Buyer of 7,500 Sea (SE) June 25 Calls for $1.90 – Stock at 25
This trade, and the subsequent volatility shift, would lead me to believe earnings are now in June. As the graphic below shows, the May volatility is down 6.7 points and now below the June volatility. Yesterday the May volatility was approximately four points higher than June … and today June is now 2.5 points higher than May (48.8 vs. 46.19).
The earnings date for SE is still not confirmed. However, by paying attention to the price of options/volatility you can get a good read on when the options market is predicting a company will report.
Below is an options education article I wrote several years ago demonstrating that while Covered Calls/Buy-writes are considered a safe trade, and Naked Put Sales are perceived to have high risk, at the end of the day they have the EXACT same risk/reward.
Buy-Write vs. Naked Put Sale
Buy-writes, also known as covered calls, are one of the general public’s most popular options trading strategies. Selling naked puts (the sale of a put in an stock or index without a stock position), on the other hand, is feared by the general public as it’s considered to have much greater risk than a traditional buy-write. But when you break down the profit and loss potential of the two strategies, you can see that they’re identical.
Let’s start by looking at a buy-write/covered call:
A covered call is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income. Because the trader sold a call against his stock position, his upside is now limited.
For example, let’s say you own 100 shares of Alcoa (AA), which is currently trading at 13.99. You then theoretically sell one AA July 14 Call (expiring 7/19/2014) for $0.51 for each of your 100 shares.
Let’s take a look at a few scenarios for this trade:
In this scenario, AA shares trade flat for the next month and the stock stays below the 14-strike price. At this point, the options you sold will expire worthless, and you will have collected your full premium of $0.51 per share ($51). Thus you will have created a yield of 3.78% in one month’s time.
In this scenario, AA shares fall to 13.48. At this point, the options you sold will expire worthless and you will have collected your full premium of $0.51 per share ($51). However, your 100 shares of AA will have lost $51 of value. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls against your stock position.
In this scenario, AA shares fall to 13. Once again, the options you sold will expire worthless and you will have collected your full premium of $0.51 (or $51). However, your shares of AA will have lost $99 of value, leaving you down $48 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.
In this scenario, AA shares rise above 14. At this point, the owner of the 14 calls will exercise his right to buy the stock from you. This will leave you with no position. However, you have collected your $0.51 (or $51) and made $0.01 on the stock position.
Here is the profit and loss graph of this trade:
Now let’s take a look at the scenarios of selling a Naked Put in the same stock. (Remember, selling naked puts is the sale of a put in a stock or index without a stock position.) With stock AA trading at 13.99, we could sell the July 14 Puts (expiring 7/19/2014) for $0.51.
Let’s take a look at a few scenarios for this trade:
In this scenario, AA shares trade flat for the next month and the stock stays below the 14-strike price. At this point, the options you sold will expire in the money, and you will have collected your premium of $0.51 per share ($51). Now you will be long the stock, but will have created a yield of 3.78% in one month’s time. At this time, you could simply sell the next month’s calls against your stock position.
In this scenario, AA shares fall to 13.48. At this point, the puts you sold will expire in the money. Thus you will buy the stock at 14. However, since you collected your full premium of $0.51 per share ($51) this makes up for the loss on the stock. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls (switching to a buy-write now that you own shares) against your stock position.
In this scenario, AA shares fall to 13. At this point, your puts are in the money so you will be forced to buy the stock at 14. You will have collected your full premium of $0.51 (or $51). However, your shares of AA will have lost $99 of value, making you down $48 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.
In this scenario, AA shares rise above 14. At this point, the puts you sold will expire worthless and you will have collected your full premium of $0.51, or a yield of 3.78%.
Here is the profit and loss graph of this trade:
So what jumps out about these two charts? They are absolutely identical! The most you can make is the same, and the most you can lose is the same.
We can go through this exercise hundreds of times but each time the profit and loss graphs will be identical. Thus, executing a buy-write is “synthetically” identical to selling a naked put.
Jacob Mintz is a professional options trader and editor of Cabot Options Trader. He is also the founder of OptionsAce.com, an options mentoring program for novice to experienced traders. Using his proprietary options scans, Jacob creates and manages positions in equities based on risk/reward and volatility expectations. Jacob developed his proprietary risk management system during his years as an options market maker on the Chicago Board of Options Exchange and at a top tier options trading company from 1999 - 2012. You can follow Jacob on Twitter.
By Michael C. Thomsett
Implied volatility is an estimate based on current levels of price and moneyness, but these matters change every day.
Timing of option trades is likely to be improved by relying more on price-related and momentum signals, and not aimed at the effort to estimate future volatility. Today’s volatility tells traders what they need to know to time their decisions profitably. Consideration such as moneyness and proximity matter. When the current price per share is close to the option strike, timing is likely to be improved, whether entering or exiting. Another form of proximity is related to price in comparison to resistance or support. Most reversal signals are most reliable when they occur right at these trading range borders. If price gaps through resistance or support, and reversal signals appear, this is exceptionally strong timing for options trades.
Options traders often prefer implied volatility (IV) to time trades, but this rarely makes sense. IV has value to some extent, but it is an estimate only and is based on what you see today, not on what is likely to happen in coming days or weeks. Traditionally, traders like to enter long trades when IV is low and exit when it increases; or to enter short trades when IV is high and exit when it declines. However, analysis reveals that this is equally effective when applying the analysis to historical volatility, which is more reliable because it is factual and not an estimate.
Support for relying on IV comes largely from academia, where IV is tied directly to the efficient market. However, this also is flawed. The efficient market hypothesis (EMH) states correctly that prices efficiently take news into the price immediately. However, no distinction is made between true news and rumor, so false information has the same effect on price as true information. This efficiency also fails to identify how far a stock price should move. Anyone who has observed market reaction to earnings surprises sees a big price move, often exaggerated. In comes sessions, the price retraces to previous level.
This is not efficient.
That’s the entire point. EMH is poorly named because it implies that markets are efficient, when in fact only discounting of all information (true and false) is efficient. When options traders rely on IV and point to “efficiency” as justification, they are relying on a signal containing no true value.
Proponents of IV claim that (s) the market is efficient, and this is reflected in IV and (b) this fact allows traders to accurately predict the future.
However, the efficiency of price behavior based on information often gives off a false signal, so that IV itself reflects the inefficient interpretation of price. Traders know that short-term price behavior is inefficient and chaotic, so that IV – as a direct factor of this assumption – is not reliable for timing trades.
A related problem is the significant variance in IV based on moneyness of different strikes and time to expiration. Informed short traders know that time is an ally, and time decay is a primary source for profits. However, this is easily based on historical volatility rather than on the less reliable implied volatility. A debate about which form affects option premium is unsettled; but traders will discover that relying on historical volatility provides reliable timing information to exploit volatility.
The problems with IV are evident in the wide variances of levels based on moneyness and time to expiration. This tendency to vary is called the volatility surface, and it relies on current option premium levels as the source for future movement; in truth, those premium levels are not the source, but the result of historical volatility and moneyness. A detailed study of stock and option prices concluded that there is no consistent evidence that IV determines or affects future option value. 
IV is not accurate or reliable, despite common belief that it is both. Another study pointed out that IV is not a valuable indicator at all:
In theory, the implied volatility is the market’s well-informed prediction of future volatility. In practice, however, the arbitrage trading that is supposed to force option prices into conformance with the market’s volatility expectations may be very hard to execute. It will also be less profitable and entail more risk than simple market making that maximizes order flow and earns profits from the bid-ask spread. 
Although there are five factors going into the Black Scholes pricing model (BSM), only volatility is unknown and must be estimated; and this is where inaccuracy comes into play, making the pricing model deeply flawed.
The intent of IV is to identify current volatility and predict future volatility, but it cannot predict the future. Volatility itself (defined as “risk”) cannot be quantified for the future in any case, so any assumption by traders that IV is a reliable test of future price movement, is simply untrue. This is easily demonstrated by another factor: Volatility reveals the likely movement of an option’s premium, but not the direction. Options traders are naturally interested in figuring out where the price will move, but volatility articulates the range of price movement and not the direction.
A final flaw is that as expiration approaches, volatility will become as uncertain as price of the underlying. This “volatility collapse” makes IV unreliable in the final week before expiration. But this is the week where many traders focus. If a trader is active in the final week of the option’s term, but also relies on IV, there is no certainty whatsoever of profitable outcome. A simple observation of moneyness and proximity to resistance or support makes more sense.
The use of IV can be compared to reliance on forward P/E. This is an estimate of future P/E but contains assumptions, often based on wishful thinking or flawed assumptions. It may also be compared to the accounting reliance on pro forma financial statements, estimates of future revenue, costs and net profit. This may be based on detailed forecasting that sounds scientific but, in fact, cannot be called accurate. If traders know that estimates of future P/E or net profits are unreliable, why depend on IV to estimate future volatility of options?
 Bouchard, Jean-Philippe & Marc Potters (2009). Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management (2nd ed.). Cambridge UK: Cambridge University Press. p. 252
 Figlewski, Stephen. (2004). Forecasting Volatility, New York University Stern School of Business, Preface
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
By Reel Ken
The Theory is pretty easy to understand. It is backed up by mounds of statistical proofs and observations. Advanced math skills are not necessary. It is really borne out of two separate but interrelated concepts … 1) Market Performance and 2) Individual Performance. Let’s take a look at these two elements:
A statistical proof exists; separate from data collection or observation, that indicates the market should have an upward bias (or positive skew). Observations and data, collected over the last 100 years confirm this to be true. It is noteworthy that the data confirms the theory and not the other way around. One doesn’t need a statistics degree to confirm this … they need only look at any long term chart and they can easily see that the market is an ever upward climb.
Of course it has it “fits and spurts” but the upward bias is obvious to all that take the time to look.Though there is some discussion of how large this skew is, most studies indicate that the market is up 60% to 70% of the time. This seems to hold true when viewed over decades, years, month, weeks and even days.
This is a little bit trickier to explain … but I’ll do my best. First, we must differentiate between the “trader”, the “market timer” and the long term investor. There have been many studies of professional money managers and individual investors that differ somewhat in their quantitative results but agree in the overall result … most investors (pros and DIY) underperform a simple buy and hold of abroad market index. Furthermore, this underperformance is not small … in some studies is as much as 5% per year in the short term, and even more in the long term
Time Period (ending Dec. 31, 2014)
Average Equity Fund Investor Return
S&P 500 Average Return
Simply put: The most effective investment strategy is “buy and hold” but few actually accomplish this end. The reason seems to be pretty simple … the average investor is driven “emotionally” not logically.Every seasoned investor has experienced this ... or they are kidding themselves. No one … yes, no one … is immune.
Additionally, asset allocations such as the most popular 60%/40% stocks/bonds are widely recommended. Contrary to this, the data indicates that the most effective allocation is actually 100% stocks. By example, if we took the Five Year results from the above chart we would have a 10% Equity return. But if one was, say 60% in stocks, the equity return as a percentage of their portfolio is closer to 6%. So, on a portfolio basis they are not achieving anywhere near the 10% return. Contrast that with over 15% had they just simply put all their assets into an index fund and not engaged in any trading activity.
Of course, very few investors will accept this because of the risk of loss in down years (we all remember 2008). But, once again, the path is clear … it is the emotional courage that is at issue. Even the worst of down years are regained in a couple of years. Nonetheless, investors seem willing to accept less than optimal returns in exchange for some degree of safety.
Calendar Option Theory
Let me be emphatic that this conversation is about utilizing calendar spreads as an adjunct to or as a core position. It is not targeting “one-off” trades”. That’s for another day.
So, this brings us full circle to the theory behind calendar spreads (and most hedges, for that matter). Investors should seek out ways to be fully invested and also limit their downside risk. The theory is based, mostly, upon the fact that most investors would have increased PORTFOLIO returns if they abandoned traditional asset allocation mixes (such as 60%/40%) and, instead put 100% of their portfolio in an index fund and bought a far dated put to protect the downside.
It is so with calendar spreads. One can expand their allocation towards equities, and away from bonds, while protecting against loss.
Of course, the far dated put detracts from returns, but the ability to be 100% equity invested, the ability to have a cap on the downside (usually less than 5%/year) will enable the investor to outperform traditional asset allocations and … most importantly … enable them to avoid panic and emotional selling.
Now, with this theory behind us, let’s look at calendar spread methodology.
First the time to employ a calendar spread is during a rising market (or at least a flat market) when volatility is average or lower. This is common sense. The far-darted long put wants to be bought at the most economical price and lower volatility lowers the cost. Not rocket science.
Next, and the more difficult part, is the setting of the near--dated put-write. This is complicated because one needs to consider the strike; the expiry; and when to roll. So let me give some guidelines.
One can “play around” and try to guess the market and go ITM, ATM or OTM as they please. My personal experience and the rather dismal track record for “market timers” would discourage this in favor of a more systematic approach. This approach would be based upon the concept that the market has upward skew. It is also aided by the fact that the downside is limited and protected by virtue of the long, far dated put.
That being the case, the put-write strike should be as deep ITM as practical. Simply stated, it replaces a long equity position. The further ITM it is placed, the closer it comes to mimicking a long equity position.
Remember: One sells a near-dated put instead of an outright buy of the underlying, to try to capture extrinsic with the hopes that it will offset the cost of the far-dated.
There aren’t a lot of studies that would indicate how DITM it should be set, but if done as a monthly strike, 2% seems to be confirmed in at least one study. But before someone hops on that, we need to look at what is the best expiry.
When one sells a DITM put, it favors selling shorter durations provided the move --- in the direction of the strike --- does not exceed TWICE the premium collected. This is true whether one is comparing a weekly to a two-week; a weekly to a monthly; or a monthly to a quarterly; or even a weekly to a leap. So, if one sold a near-term put and received, say, $5 in premium … the near term is favored over any far-dated, provided the underlying doesn’t rise more than twice ($10) the premium received.
Strike and Expiry
Unfortunately, this is sort of a balancing act and there is no definitive study that helps us out. Combining the two elements, my experience is that selling a weekly 1% ITM is the right level. However, that holds only on an underlying with a Beta of 1 (SPX). If the underlying Beta is, say, 1.5, then the strike should be 1.5% ITM …and so on.
The 1% ITM shows gains in and of itself and compared to a further-dated as long as the weekly move is less than 2% up. Now, there will be times that the move is greater than 2%up. This will happen, on average, 4 times a year. But the frequency of large up moves may be offset by “Holding the Strike”.
Holding the Strike
This is the most important part of selling puts (calendar spreads or naked puts). If there is a drop, do NOT lower the strike and try to capture more extrinsic. Always be willing to sacrifice extrinsic on a down move in order to be prepared for the inevitable bounce back up. It may come in a week; a month; or a year. But the market, historically and scientifically has always (yes, ALWAYS) rebounded.
The real danger to a calendar spread is losing short term value on a big move down and then not fully regaining it on a bounce (the “whip-saw”) Always keep in mind that the far-dated protects the downside … “holding the strike” protects against the “whip-saw”.
Additionally, many times a big up move will follow a down move. So, holding the strike will reduce the frequency of being over-run.
Combining these three ingredients, one should sell the short put on a weekly basis; the greater of 1% ITM or the previous strike.
Rolling the PUT
As long as the PUT is ITM, it is best to hold till expiry to maximize theta decay.
However there will be times when one sets the strike 1% ITM on Friday and on Monday the market moves up 1%. What to do? Will the market drop by week’s end? Or, will it continue up?
There is no answer. The market will do what the market will do. History tells us that it is 60-40 going to go up. That may be sufficient reason to raise the strike. Even if the strike holds, you would have raised it another 1% on expiry under a normal roll, so at worst, you’re doing it a little early. Rolling up ½% now would be a cautious minimum.
A greater dilemma occurs if the move is greater than 1% early in the week and you’re now OTM. If a strike is over-run and then rolled up, you incur a permanent loss of some amount. However, I’d consider rolling up on the basis that even if there is a drop down, theprevious level will be regained.
Knee-Jerk or Fundamental
With all that said it is worthwhile to evaluate the character of any big move. Is it knee-jerk or fundamental? Has something changed or is it concern over the possibility that something may change? Every investor needs to consider these factors. If there is a fundamental deterioration in the economy, then one might want to be somewhat more defensive on the near-term put-write. My best advice is to make any such determination carefully and don’t be afraid of getting there a little late. The far-dated put protects. So it is never an issue of suffering large losses, it is more about possibly making money during the bear, while others lose money.
Calendar spreads bring with them problems that all investors must face … what to do? These guidelines can resolve what to do on a down move… Hold The Strike. What is so simple in a calendar spread is usually the most difficult decision investors using traditional methods face.
These guidelines also resolve what to do on more modest moves (less than 1%/week). Stay the course.
Over-runs are more problematic. They resemble the issues that traditional investors face on up moves. Is it going further or is it coming down? The only way to fully resolve this is to make a determination as to whether it is a knee jerk or fundamental move.
However, absent clear signals that a fundamental change has taken place … be willing to err by adjusting on the side of the market going up, even more.
Ken Reel is a well known and respected Seeking Alpha Contributor with over 100 articles. He has worked in the financial service industry for 40 years. Ken's area of expertise is risk management and complex financial products. He has been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. He has extensive experience in statistics and actuarial science.
By Nathan Wade
As public fear escalates, demand for protection against downward shifts in the stock market increases with it. This boosts the premiums for options that can be used to hedge against downward shifts in stock prices.
While some investors invest in either stocks or options, many investors use options to hedge their stock portfolios. They look for overvalued options, so that they may sell options when the premiums of those options are expensive. The best way to determine if an option premium is overvalued is to analyze implied volatility.
What is Implied Volatility?
Let’s say you have a call option. When you hold a call option, you have the right (but not the obligation) to buy a security at a specific strike price on or before its expiration date. The value of this option is determined by the probability that the call option will be in the money by the time it reaches its expiration date.
To determine the likelihood that an option will be in the money before the expiration date, you need to figure out how quickly it will move in the right direction. But how do you do that?
Option traders, like Warren Buffett, turn to implied volatility. Implied volatility is a measure of how much market participants believe the price of a security will move over a specific period on an annualized basis. It’s typically represented as a percentage.
An implied volatility of 20% means that traders estimate a security will move up or down 20% from its current position over the next 12 months. To determine the premium, or price, of an option, you could use an option pricing model. The most famous is the Black Scholes option pricing model. There are several inputs, but the most crucial is implied volatility.
How Do You Measure Implied Volatility?
There are a few ways to measure implied volatility—but the easiest way is to evaluate an available index of implied volatility.
You can chart implied volatility on several instruments including the VIX volatility index. Additionally, you can use technical analysis tools such as Bollinger bands and the RSI to help you decide of the value of implied volatility is rich or cheap.
The VIX volatility index, which is calculated by the Chicago Board of Options Exchange (CBOE), lists the implied volatility of the “at the money” calls and puts on the S&P 500 index. The VIX reports how far traders believe the S&P 500 will move over the course of the next year.
The CBOE produces many different VIX indexes. There is a VIX on Apple shares and a VIX on crude oil. By charting the VIX, you’ll be able to determine whether implied volatility is rich or cheap.
How Do You Know When Implied Volatility is Rich?
When implied volatility is high, or “rich,” option prices are overvalued. This attract investors like Buffett. This is when you want to sell options.
You can determine how rich volatility is by using technical analysis tools like Bollinger bands or the Relative Strength index. When the value of the VIX moves up to unsustainable levels, you’ve reached a trigger point. This is where you should look to sell options.
Bollinger bands are a technical analysis tool that measure a 2-standard deviation range around a moving average.
The chart of the VIX shows that the VIX shot above the Bollinger band high in early October, which was calculated using a 200-day moving average. This also happened in March and February of 2018. When the VIX crosses above the Bollinger band’s high, it’s likely to revert back to the mean. But before it returns, you can attempt to sell an option. You can use several different moving averages to determine if the value of the VIX volatility index is high. It all depends on your time horizon.
A second technical analysis gauge you can use to determine if implied volatility is rich is the relative strength index (RSI). This is a momentum oscillator that measures accelerating and decelerating momentum along with overbought and oversold levels. When the RSI moves above 70, the value of the security is overbought and will likely correct itself. In early October the VIX hit an RSI reading of 84, well above the overbought trigger level of 70—meaning the volatility was rich.
There are other tools that you can use to measure implied volatility. There are vendors that provide historical charts of implied volatility on individual stocks. You can use the same type of technical analysis tools to determine whether the implied volatility on these shares are rich or cheap.
When Should I Check Implied Volatility?
You can use implied volatility as a confirmation indicator or a trigger. The process goes as follows:
Once you find a stock that you believe is undervalued, you might consider selling a naked put below the current stock price.
You would then check the stock to see if current implied volatility is elevated and use that to determine whether or not selling an option on that stock is worthwhile. Alternatively, you can use implied volatility as a trigger. In this case, you could scan for implied volatility levels on stock prices where the Bollinger band’s high has been breached or the RSI is above the 70 overbought trigger level.
You can then find a level that would make selling a naked put or a covered call attractive.
A Final Message
The best options strategies are income producing option trading strategies. These include popular trading strategies, such as covered call and naked put trading. It does not matter if you are selling a naked put or employing a covered call strategy, you want to sell options when premiums are overvalued.
FB is one of the mostly watched stock in the US stock market. Many options traders try to play earnings using FB options.
There are few alternatives. We will backtest them using CMLviz Trade Machine.
1. Buying Call Options
This strategy involved buying call options on the day of the earnings announcement and selling them the next day. Here are the results:
Tap Here to See the back-test
This doesn't look so good. How about a bearish trade?
2. Buying Put Options
This strategy involved buying put options on the day of the earnings announcement and selling them the next day. Here are the results:
Tap Here to See the back-test
Looks much better. However, this result was heavily impacted by the last earnings release. You remove the gains from the last cycle, the strategy would be a loser as well.
Tap Here to See the back-test
How about buying a straddle (both calls and puts)?
3. Buying a straddle
This strategy involved buying a straddle on the day of the earnings announcement and selling them the next day. Here are the results:
Tap Here to See the back-test
Once again, big chunk of the gains came from the last cycle when the stock tanked ~20%. Removing the last cycle causes the overall return to become negative:
Tap Here to See the back-test
How about selling the straddle?
4. Selling a straddle
This strategy involved selling a straddle on the day of the earnings announcement and selling them the next day. Here are the results:
Tap Here to See the back-test
Overall loss - but again, ALL of the total loss came from the last cycle. If we remove the last cycle, the overall result becomes positive:
Tap Here to See the back-test
We performed the back testing using the CMLviz Trade Machine which an option back-tester created by Capital Market Laboratories (CML). It is a very powerful tool that allows you to back test almost any possible setup.
Tap Here to See the Tools at Work
Those backtests confirm what we already knew (more or less):
Buying straddles before earnings is on average a losing proposition. You will lose most of the time, but you might win big couple times when the stock makes a huge move.
Chart from optionslam.com.
Based on those statistics, many options "gurus" suggest selling options on high flying stocks like FB,AMZN, NFLX etc. They claim this is a "high probability strategy".
What they "forget" to mention (or maybe simply don't understand) is that high probability doesn't necessarily mean low risk.
Here is an excellent example used by our guest contributor Reel Ken:
We load a six-shooter gun with one deadly round and play Russian Roulette for $100 per trigger squeeze. The odds are 83% (5/6) that you win. Does that make it low-risk? What would low-risk look like? How about a 13-round Glock where your probability of success is over 90%. For certainly, if one defined risk as favorable odds, we would expect many takers, but I'll bet there wouldn't be any.
The reason is simple: One doesn't define risk by the probability of success. I often see this mistake when pundits promote investing strategies such as selling deep-out-of-the-money-puts (DOTM) on volatile stocks and lauding the low-risk-nature of the trade. "The stock would have to drop over x% (6%,7%, 10%) for you to lose". Well, Facebook reminded us of the real risk in such strategies.
Yes, risk isn't the chance of loss, it is the magnitude of potential loss. Too many simply confuse probability with risk.
This confusion is because investors don't understand there is a completely other operative metric. They can easily put their hands around the potential loss and even recognize when a probability is very high or very low (I hope).
But probability isn't risk. And, though maximum loss is risk, maximum loss is very, very rare. The maximum loss on the S&P is it going to ZERO, and though that's possible, it isn't helpful for us to evaluate investing loss.
Lets check how this strategy would work for FB in the last cycle, by selling 1 SD strangle on the day of earnings. With the stock trading around $217, you would be selling 232.5 calls and $202.5 puts, for $208 credit. This is how P/L chart would look like:
The trade would tolerate around 7% move in each direction, which would work well most of the cycles. Based on the options deltas, the trade had ~70% probability of success. Not bad.
As a side note, the trade would require around $2,850 margin, so even if you kept the whole credit, your return on margin would be around 7%.
Fast forward to the next day after earnings have been announced and the stock was down almost 20%:
The trade was down a whopping $2,407, which would erase 12 months of gains (even if ALL previous trades were winners).
Earnings are completely unpredictable. In order to make money from earnings trades held through the announcement, too many things have to go right and too many things can go wrong. Selling options around earnings have an edge on average for most stocks, but they have a much higher risk than buying options, especially if the options are uncovered. Don't confuse high probability with low risk. You can win 70-80% of the time, but you can also lose few times in a row. And when you lose, you can lose big time. Those "one in a lifetime events" happen more often than you believe. Even if you did your homework and backtesting and decided to hold your trade through earnings, always assume a 100% loss and size your position accordingly. Even if the backtesting shows 90% winning ratio for a certain strategy, one huge move (in any direction) can erase months and months of gains. The bottom line: trading options around earnings can be a very profitable strategy - but closing the positions before earnings will produce much more predictable and stable results with much less volatility.
"Trying to predict the future is like driving down a country road at night with no headlights on and looking out the back window." - Peter Drucker
Why We Sell Our Straddles Before Earnings Why We Sell Our Calendars Before Earnings How NOT To Trade NFLX Earnings Betting On AAPL Earnings?
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