By Michael C. Thomsett
Of course, this makes no sense. Volatility changes constantly, ands this points out the problem with any model. It must assume that volatility remains unchanged for the math to work out. Even so, the assumption is so flawed that it makes the model unreliable. Making matter worse, the BSM has many other flaws as well. In math, one flaw is bad enough; but when you face at least 8 flaws (as BSM dies), it means there is zero reliability. 
But it gets worse.
Volatility is unpredictable. Even with the high number of flaws that create unaccounted for variables, the volatility problem is more severe. With fixed volatility, the degree of standard deviation is predictable, but this is not how things work in the real world. Price movement is chaotic, meaning that volatility is also chaotic and unpredictable. High and low volatility occur when price behavior is narrow and, on the other extreme, when it is broad. But how can this be predicted? It cannot. Volatility never remains unchanged, and it never changes in a predictable manner, or in a straight line.
Volatility does not anticipate direction or degree of price change. Even though the BSM assumes volatility remains unchanged, another problem must be recognized. Even if the degree of today’s volatility remained unchanged, which direction will price take? Will it rise, fall, or remain unchanged? High daily volatility can occur within a range of price, but from day to day exhibit no significant movement. This is a factor never anticipated in BSM or, for that matter, in any pricing model. The flaws about volatility are more complex than the initial assumption that volatility does not change. Beyond direction of price movement, even fixed volatility does not reveal the degree of price movement in the underlying. A 5% move in a stock selling for $30 per share implies a 1½ point change. But if the price per share is $90, the same 1½ point movement is 4½ points. The assumed degree of volatility is not fixed but varies based on the underlying price range.
The timing of price changes also affects volatility. Does the underlying advance and then decline, or does it move in the opposite direction? Are there extended periods of consolidation? Every underlying behaves different, causing great variability in how volatility reacts. The option contract changes based on underlying price movement, and a correlation between the timing of price trends, and the volatility of the option, cannot be overlooked. The time required and the sequence of movement are further affected by moneyness and time to expiration.
Moneyness also affects volatility. The BSM assumption is normally applied to any option, regardless of its proximity to the strike. This is also unrealistic. ATM options have the highest gamma levels, so there are obvious differences between ATM, OTM and ITM contracts. And the greater the distance to strike, the greater the effect on volatility. It cannot be assumed in any situation that the option is ATM and will remain there. If it would, then no pricing model is needed. Nothing moves. But in practice, as an option moves ITM or OTM, gamma will change as well. Volatility changes as the distance grows.
Time to expiration also affects volatility. A shorter-term option is likely to exhibit higher gamma than longer-term options, and the time span affects volatility directly. As expiration approaches, gamma should increase as well (assuming offsetting movement in moneyness does not change the calculation). In applying a price model, it is unrealistic to base assumptions on an option remaining ATM because, as movement occurs (and as expiration nears), the entire matter of gamma changes drastically. As expiration nears, volatility behavior also changes. Even if a trader could know the volatility level near expiration, a pricing model is likely to undervalue an ATM option as volatility rises, and to overvalue the ATM option as volatility declines.
Type of option trade distorts volatility assumptions. Is the trade a long contract or a short contract? Is it a spread or a straddle? The nature and attributes of trades matter and volatility is going to vary based on the trade itself. A related issue is the historic volatility of the underlying. A highly volatile underlying price will directly affect option premium and its implied volatility. When this point is expanded to different types of trades, the overall problem also becomes clearer. Not all trades are the same, so BSM assumptions about volatility are more complex for some trades and combinations, than for others.
Adjusting for stochastic volatility (SV) creates yet another variable. Under the BSM model, volatility is assumed to remain constant. Applying Stochastic volatility, the assumption is added that volatility varies as time passes. This does not make the calculation more reliable; it only adds one more random variable. This may allow for analysis of a range of possible pricing outcomes, but it remains a guess to matter how many variations of the model are used.
The problem remains: No pricing model can accurately forecast option prices in the future. Those few theorists who swear by BSM must ignore the facts, but any model contains flaws and imperfections. The solution is not to develop better methods for calculating volatility, because it is entirely unpredictable. The solution is to identify strategies and risk limiting methods to survive in an uncertain world.
 The 8 most serious flaws of BSM are: (1) Volatility remains constant (2) there is no restriction on buying or selling the underlying; (3) no tax consequences apply to profits; (4) interest rates are fixed and available to all; (5) no transaction costs are in effect; (6) trading is continuous without any gaps in price movement; (7) volatility is independent from underlying price; and (8) price changes are normally distributed.
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 Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
By Michael C. Thomsett
The best known form of volatility is based on underlying price behavior. Historical volatility has certainty, because it reflects price activity in the recent past, with no estimates of the future. Options are derived from the underlying price activity, and option premium is derived from historical volatility. This does not tell us what will happen next, but it does provide a means for comparing risk (volatility is risk, in fact). In looking at historical volatility for several underlying issues, it becomes natural and easy to compare risks from one to the other.
The historical record of volatility allows traders to estimate the likely risk level, based on possible price movement. The longer the period analyzed, the more reliable this will become. If an underlying his displayed low historical volatility over many years, it is less likely that high implied volatility of the option will follow, at least when comparted to an underlying with much higher historical volatility.
It can be calculated using several variables. The most reliable are (a) the period being studied and (b) the interval between price movement and change (daily, weekly, monthly, for example). The best-known and most often used are one year and daily price changes but using a smaller number of daily sessions also focuses current volatility on the most recent information.
Despite widespread popularity of implied volatility, the fact is that the underlying historical volatility is probably the most reliable measurement of risk in both the underlying and its options.
A popular but somewhat uncertain test is implied volatility of the option. This calculation is nothing like that for historical volatility. It is strictly an estimate of future volatility, based on some assumptions (which themselves are subject to interpretation). Many options traders swear by implied volatility but questioning why this is so makes sense. Would the same trader rely on underlying price change based on recent historical volatility? Probably not. It doesn’t make any sense. The same logic can be used to question implied volatility and its value.
A good question to ask is which volatility is used by the market. Few traders not using options will ever try to estimate implied volatility, because that belongs only to the options market. This does not make it reliable; in fact, can anyone say that all options traders are using the same pricing model? No. In fact, there are many pricing models, and even those using the same one (i.e., Black Scholes) are probably not using the same assumptions to determine volatility. Implied volatility is subject to a lot of interpretation and it is most loved among academics, but much less among traders. That may be the bottom line and the most revealing fact of all.
This is the volatility that every trader dreams of understanding, by whatever name it is given. This is the future distribution of prices for the underlying. No one who has followed the broader markets will be able to claim that they know what future volatility will be. In fact, one characteristic of the market is that it constantly surprises all its players, and no one can accurately predict what future volatility will be, not to mention the direction of price movement.
If you can guess at the right probability, you can accurately predict future volatility. But probability is just as elusive as all other market factors, and no one can know what will happen tomorrow, next month, or next year. It is equally impossible to know ahead of time what factors will cause markets to rise or fall. There are so many, including those not yet known or understood by anyone.
Every market has its share of “experts,” people or companies that confidently predict volatility in coming days, weeks or months. They cite numerous justification for their opinions, but it is unlikely that anyone has gotten rich investing or trading based on estimates of forecast volatility.
Ironically, many forecasters claim that they rely on the fundamentals, but forecast volatility is as technical a signal as anyone can find. It is all guesswork, and the only certainty available is that time value declines as expiration approaches, and the day after expiration, every option is worth zero. This knowledge is known in advance by every trader, but with options, the idea is to gain in-the-money value (for long options) despite the knowledge of how time works against the long position (and in favor of the short position). Forecast volatility for options is no more reliable than for the underlying, because these two are related. As the underlying behaves, so too will the option (given the added variables of time decay and expiration).
A final version may be called seasonal volatility. For options on futures contracts, this is well understood for agricultural contracts, but for equity options, is there a seasonal version? There is, in fact. For example, in a political year, the season approaching election day has everything to do with risk. Which candidate will win, and how will that affect overall markets and options? The 2016 election say dramatic and sharp increases in equity value right after the election, contrary to dire predictions offered by many “experts” on market matters. Will 2020 have a similar cause and effect based on which candidate wins?
The same observation can be applied to off-year politics, to future volatility guesswork, and even to the weather. The important factor to keep in mind is that volatility in most forms is largely a matter of guesswork, and at times the “educated” guess may be just as dubious as the arbitrary or uneducated guess.
This is the problem with volatility. All traders, including options traders, constantly seek a reliable method for improving timing and reducing risk. If that were possible, every trader could become rich because beating the odds is an intrinsic part of the options world. But it is not actually possible for anyone. Volatility could be thought of as another word for the term “uncertainty.”
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 Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
By Ophir Gottlieb
Whatever it was, the VIX went from 17% to 37% in a matter of two-hours, or up 115%. That is the largest percentage gain in the VIX in one day ever recorded.
Even then, while that is a huge move, it wasn't really market disruptive in any great way other than, the market had a bad day. But then the after hours margin calls came in -- and that was an unmitigated disaster for one particular instrument of interest to us: Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN (NASDAQ:XIV).
DON'T LISTEN TO TV
The reporters on television have no understanding what XIV is -- it is not a naked short bet on VIX. No, it is an investment in the core underlying principle of market structures, driven by positive interest rates, known as Contango.
Remember, the XIV is the opposite of VXX, and the expected value of VXX is zero. Here it is, from the actual VXX prospectus:
This instrument is not a radical short trade, it is fundamentally an investment in an ETN that reverses the value of an investment that is ultimately expected to be zero, which made it so good, for so long, and would have for several more decades.
WHEN A LINE BECOMES THE FOCUS
A little detail in the prospectus of XIV is that, hypothetically, should it lose 80% of its value from the close, it would cause a "acceleration event." That means that if the XIV sunk to 20% of its value, it would go to zero and the ETN would go away (and start over later).
Now, obviously, this had never happened to XIV before, but it's only a decade old. When scientists back-tested XIV all the way back to the 1987 crash and including the 9/11 terror attacks, they noted that even then, XIV would not have suffered a 80% decline in a day. But we have never seen such a market with so many naked short vol sellers as we have today.
As a barometer, even as crazed as Monday was, here is how XIV closed:
Down 14.32% is ugly, but, it's just a day -- a bad one, but nothing really all that crazed. Then the after hours session happened, and the best anyone can tell, as of this writing, is that some firm (or fund) had to unwind a short volatility position due to a margin call.
That meant they had to buy the front month expiration of the VIX futures, leaving the second month unchanged. That little detail is everything, because the XIV is an investment on contango -- when the second month is priced higher than the first month. This is a market structure apparatus -- we could call it "normal market structure."
But, with a flood of buying to cover short front month futures, the XIV started tumbling after hours. At first, social media saw it as a buying opportunity. Then it started dropping faster. Then disaster struck.
The XIV dropped more than 80%:
The financial press did its best to cover it, but after a 2 minute segment on CNBC, there was nothing left to say because of one major rule inside the XIV prospectus. Here it is:
In that fine print, it reads that if the value of XIV dips to 20% of the closing value (if it is down 80%), the fund stops. That is, since this trade, if done with actual futures contracts, can actually go negative, the ETN stops itself out at a 80% one day loss. This is why we investors use the ETN, knowing that a 100% loss is the worst that can happen, as opposed to the futures, where much worse than 100% loss can occur.
And the greatest burn of it all
As of Tuesday morning the VIX is down huge (of course it is), the market structure has held (of course it did), and XIV would be having a very good day (of course it would).
But, worse --- it turns out, as far as we know (still speculation), while it's hard to swallow, that the unwinding was done by none other than Credit Suisse itself. Yes, the creators of the ETN had another concern, beyond the assets under management -- and here it is -- -- look at the largest shareholder.
Credit Suisse quietly became the single largest holder of the very instrument it created, and by a huge amount. So, as 4pm EST came around, a bad day in XIV, but survivable, became the death knell, because the largest holder, the XIV's custodian, panicked, and covered.
But, Credit Suisse could not very well just sell millions of shares of XIV in a thinly traded after hours session, so it turned to the VIX futures market.
It appears, as of this writing, that this has actually occurred. While Credit Suisse (the issuer of the ETN) has yet to comment, it appears that whatever this "flash crash" did, whatever margin calls were triggered after hours, the short vol trader was in fact the firm -- it unwound positions in a size that the market has never seen before, and that means that it looks like XIV is possibly going to some very, very low number -- like $0, low.
It's with great regret that as of right now, we do believe XIV is, for all intents and purposes, gone, from a little rule hidden deep in the prospectus that no one gave much concern and that got blasted away when the top holder in the note was the custodian itself.
It's a reminder that the real danger to a portfolio is not a bear market -- we recover from those quite nicely as a nation -- it's the delirium that happens when a bull market gets totally out of control and margin is used excessively in a spurt of just a few days. And by margin, we don't mean normal, everyday investors, we mean the institutions -- even the ones we entrust to be custodians of our investments.
So that's it. XIV likely would have done just fine after this moment in time in the market, will not be given that opportunity to recover. It has been blown out on the heels of yet another Wall Street debacle, which no one seems to even understand, yet.
The author is long shares of XIV in a family trust.
Ophir Gottlieb is the CEO & Co-founder of Capital Market Laboratories. He contributes to Yahoo! Finance, CNNMoney, MarketWatch, Business Insider, and Reuters. This article was originally published here.
In this article, I will show why it might be not a good idea to keep those options straddles through earnings.
As a reminder, a straddle involves buying calls and puts on the same stock with same strikes and expiration. Buying calls and puts with the different strikes is called a strangle. Strangles usually provide better leverage in case the stock moves significantly.
Under normal conditions, a straddle/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.
The problem is you are not the only one knowing that earnings are coming. Everyone knows that some 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.
Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In many cases, this drop erases most of the gains, even if the stock had a substantial move. In order to profit from the trade when you hold through earnings, you need the stock not only to move, but to move more than the options "predicted". If they don't, the IV collapse will cause significant losses.
Here is a real trade that one of the options "gurus" recommended to his followers before TWTR earnings:
Buy 10 TWTR Nov15 34 Call
Buy 10 TWTR Nov15 28 Put
The rationale of the trade:
Last quarter, the stock had the following price movement after reporting earnings:
Jul 29, 2015 32.59 33.24 31.06 31.24 92,475,800 31.24
Jul 28, 2015 34.70 36.67 34.14 36.54 42,042,100 36.54
I am expecting a similar price move this quarter, if not more. With the new CEO for TWTR having the first earnings report, the conference call and comments will most likely move the stock more than the actual numbers. I will be suing a Strangle strategy. 9/10.
Fast forward to the next day after earnings:
As you can see, the stock moved only 1.5%, the IV collapsed 20%+, and the trade was down 55%.
Of course there are always exceptions. Stocks like NFLX, AMZN, GOOG tend on average to move more than the options imply before earnings. But it doesn't happen every cycle. Last cycle for example NFLX options implied 13% move while the stock moved "only" 8%. A straddle held through earnings would lose 32%. A strangle would lose even more.
It is easy to get excited after a few trades like NFLX, GMCR or AMZN that moved a lot in some cycles. However, 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.
Jeff Augen, a successful options trader and author of six books, agrees:
“There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. Unfortunately, there is no reliable method for predicting such an event. The opposite case is much more common – pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike.”
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High volatility such as this provides huge opportunity for option traders. In the article, I detailed out three potential trades for TUR – a Short Straddle, A Poor Man’s Covered Call, a Cash Secured Put and a Bear Call Spread.
I ended up going with a Short Straddle, a neutral trade, only to see the ETF drop quite quickly from $34 to $27.
As a reminder, a short strangle consists of a short put and a short call placed at-of-the-money. The thesis of the trade is that the stock will remain near the strike price for the duration of the trade and the trader will be able to close the trade for a profit thanks to time decay.
However, sometimes things do not go to plan. If the stock makes a large move in either direction, the short straddle comes under pressure.
In this example, TUR dropped pretty hard, all the way down to $26 at one point.
Here are the details of the trade and the ensuing adjustment.
Trade Date: May 30th
Underlying Price: $34.34
Sell 2 TUR July 20th 34 Calls @ $1.65
Sell 2 TUR July 20th 34 Puts @ $2.40
Premium Received: $820
By June 13th, the trade was under a bit of pressure with TUR dropping to $29.72 which was around my initial breakeven point. This was my adjustment point and I adjusted by adding a second straddle at $27.
Trade Date: June 13th
Underlying Price: $29.72
Sell 2 TUR July 20th 27 Calls @ $2.85
Sell 2 TUR July 20th 27 Puts @ $0.80
Premium Received: $730
At this point the total premium received was $1550 and by adding a second straddle I turned the position into basically a strangle.
A better was to do this perhaps would have been to turn it into a standard strangle with short calls at #4 and short puts at $27. This would have reduced the early assignment risk, but luckily I didn’t suffer any early assignment in any case. Just something to keep in mind for next time.
At expiration, TUR closed at $27.97 which resulted in a net profit of $160. Not a huge profit in anyone’s view, but certainly not too bad for a neutral trade on an ETF that dropped 18%.
In summary, this adjustment strategy for short straddles may not be for everyone, but hopefully I have demonstrated to you that it is possible to still achieve a profit even when the underlying makes a big move. In this example, we achieved a small profit, but we did add more risk to the trade in terms of more contracts.
Finally, I leave you with some words from Dr. Russell Richards regarding this type of adjustment:
“When scrambling to manage a losing trade, especially a losing undefined risk trade, most traders are happy to exit the losing trade at a “wash” or even a small loss. You will have to decide what is appropriate for you, but don’t get greedy when managing losing trades.”
What do you think about this trading strategy, let me know in the comments if you’ve tried short straddles in the past.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter. The original article can be found here.
By Ophir Gottlieb
The news was three-fold fold:
(1) The Board of Directors has named Nikesh Arora as its new chief executive officer and chairman of the Board of Directors, effective June 6, 2018. He succeeds Mark McLaughlin, who is transitioning to the role of vice chairman of the Board for Palo Alto Networks.
Nikesh Arora was the president and chief operating officer at SoftBank, but he is most famously known as the chief business officer at Google where he took the search business from $2 billion in revenues to over $60 billion in revenues.
(2) The company pre-announced that in the fiscal third quarter, total revenue grew 31% percent year over year to $567.1 million, product revenue grew 31 percent year over year to $215.2 million, and billings grew 33 percent year over year to $721.0 million.
This $567.1 million number is a whopping earnings beat, where analyst expectations were $545.68 million and in a range of [$540 million, $556.4 million]. The CFO went on to say that "[w]e had a strong fiscal third quarter 2018 and will be reporting top line and bottom line results above all our third quarter guided ranges."
(3) Palo Alto Networks will host a conference call for analysts and investors to discuss its fiscal third quarter 2018 results and outlook for its fiscal fourth quarter and full fiscal year 2018 on Monday, June 4th before the market opens.
It's that last little bit that changed everything for option traders. PANW burying its news in a late Friday press release leaves the option holders with a coin flip -- not a well measured probability bet.
On 4-27-2018, we published the dossier Applying The New Standard of Repeating Momentum in Palo Alto Networks Inc.
In that dossier we noted that "We have empirically and explicitly demonstrated the repeating pattern of bullish momentum right before earnings. [Further we find] in Palo Alto Networks Inc (NYSE:PANW) exactly the two-tiered pattern we researched again -- stocks that have pre-earnings momentum, and ones with a recent history of large beats that push this momentum into the next quarter."
These were the results over the last one-year in Palo Alto Networks of owning a 40 delta (out of the money) call 6-days pre-earnings and selling the call before the earnings announcement. Since PANW reports after the market closes, this test looks at holding the call right until the end of that trading day, and then selling before the announcement.
PANW: Long 40 Delta Call % Wins: 100% Wins: 4 Losses: 0 % Return: 175%
Tap Here to See the Back-test
But all of those results were predicated on avoiding the earnings release and we noted that the back-tested looked at a trade that closes before earnings, so this trade does not make a bet on the earnings result.
With the extremely odd news, released at an extremely odd time, this is no longer the case. Earnings be released before the market opens, and will not give option traders the ability to exit any option positions before the earnings event occurs.
In over two decades of option trading and as an option market maker on the exchange floors, I cannot recall a single time when a company announced a new CEO, an earnings beat (but with partial numbers), and then announced earnings on the same day as planned but moved the time from after the market to before the market all at once.
Usually when companies pre-release, it's very early -- like Micron did about 6-weeks before earnings in the last couple of weeks.
This is simply a case of terrible luck. Now, for anyone with an option position in PANW that intended to avoid the risk of the actual earnings news, we are left with exactly the opposite. Any position now has become a straight down the middle earnings bet - the kind most traders try to avoid at all costs.
But, this is it, there is no changing it now. For those that are long calls in the weekly options, the only hope to turn a profit on that position now is for a large earnings move up for the stock. The hope is that the pre-announcement will be backed by even better EPS and guidance news and that the introduction of a Silicon Valley super star as CEO drives the stock higher.
But, make no mistake, PANW burying its news in a late Friday press release leaves the option holders with a coin flip -- not a well measured probability bet.
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You should read the Characteristics and Risks of Standardized Options.
Past performance is not an indication of future results.
Ophir Gottlieb is the CEO & Co-founder of Capital Market Laboratories. Mr Gottlieb’s learning background stems from his graduate work in mathematics and measure theory at Stanford University and his time as an option market maker on the NYSE and CBOE exchange floors. He has been cited by Yahoo! Finance, CNNMoney, MarketWatch, Business Insider, Reuters, Bloomberg, Wall St. Journal, Dow Jones Newswire, Barron’s, Forbes, SF Chronicle, Chicago Tribune and Miami Herald and is often seen on financial television. He created and authored what was believed to be the most heavily followed option trading blog in the world for three-years.This article is used here with permission and originally appeared here.
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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By Michael C. Thomsett
For some traders, this makes little sense. Options traders tend to be pure technical traders, concerned with implied volatility and short-term valuation of options (often ignoring how stock price behavior changes over time). This overlooks the importance of historical volatility and, equally important, of fundamental volatility as well.
Fundamental volatility is the degree of reliability in fundamental trends. Items such as revenue, gross profit, net profit and net return are of little interest to many options traders but starting there is a good suggestion. How does a trader pick one or another stock for options activity? Ask several options traders and you discover that some (if not most) have never given this much thought. This should be surprising, but the culture of the options industry tends to lack the holistic appreciation of how the company directly affects option pricing.
Flaws in IV versus fundamental value
Implied volatility is often viewed as the "holy grail" of options trading. This ironic because IV is an estimate based on the current levels of historical volatility. The advantage is, IV is current. The disadvantage is, it is an estimate and several attributes going into IV are assumptions, often without solid foundation. The concept of fundamental volatility many apply to macroeconomic factors of an industry as it affects the company, or it refers to a company's profit and loss trends and ratios. It may also describe credit risk or return on investment. When considering options trading, the great debate is usually between IV and historical volatility. When reported revenue and earnings are steady over a decade, fundamental volatility is low. This usually is also reflected in stock price (historical) volatility and, as a result, in options premium and its implied volatility -- usually but not always. In determining which companies to pick as candidates for options trading, this is a good starting point.
Depending on a trader's risk tolerance, it could be preferable to pick a company with high or with low fundamental volatility. The higher the fundamental volatility, the higher the risks in options trading, and the higher the profit potential. Some traders like it this way, but others would prefer low fundamental volatility and its effect on options trading risk. Profitability will be lower, but the level of predictability is lower as well, so potentially devastating losses are less likely when volatility at all levels is low.
By mathematically calculating year to year volatility (in revenue and earnings, for example) it is easy to identify levels of fundamental volatility. A company whose revenue and earnings rise steadily over 10 years is encouraging to conservative investors; this carries over to a relative degree of safety or risk in options trading as well.
Does fundamental volatility affect historical volatility? Everyone knows that prices rise and fall for many reasons. Some can be anticipated, and others cannot. However, low fundamental volatility tends to lead directly to low historical volatility. Strong and reliable profit and loss reports are associated directly with strong and growing stock prices and earnings per share.
The correlation is not 100% predictable because other factors also are at work – competitive trends, changes in management, mergers and acquisitions, economic changes, geopolitical influences, and much more – and these also affect stock prices. However, fundamental volatility is probably a consistent influence on stock price behavior.
A secondary direct impact is seen between historical volatility of the stock, and pricing of the option. The consistent trading stock with relatively narrow breadth of trading will develop option pricing with narrow bid/ask spread and with a tendency to reflect lower than average implied volatility. This all represents lower than average risk. When the opposite occurs – higher or erratic breadth of trading and unpredictable, sudden price reversals – options are richer due to higher implied volatility. Options traders are aware of this and often view the situation as an opportunity foe higher profits. However, it also means that risks are greater.
The measurement of fundamental volatility and its direct effect on historical volatility and option implied volatility, essentially defines levels of risk. This is seen in variations of bid/ask spread, movement in premium levels, and open interest.
A complete study of fundamental volatility should begin with the study of revenue, earnings and net return. It can be further expanded into a study of dividend yield ands the payout ratio, P/E high and low each year, and the debt to total capitalization ratio, which tests working capital more effectively and accurately than the more popular but less reliable current ratio. Of the many fundamental trends and ratios, a small number can be used to articulate fundamental volatility. Focusing on revenue and earnings, dividend trends, annual high/low of the P/E ratio, and long-term trend of the debt to total capital ratio will reveal whether a company is a conservative or high-risk candidate for options trading. This eliminates the all too common problem faced by traders: Considering themselves conservative but making trades that are high-risk.
In the options world, the question of risk tolerance and methods for picking appropriate strategies and making trades on appropriate issues, should provide the method for making sure risk tolerance affects how decisions are made. This is not practiced by all options traders, and that explains why timing problems arise and why losses occur as often as they do. As long as a conservative trader makes conservative choices, leaving the speculative traders to the willing speculator, the problems of poor selection can be reduced and eliminated.
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 websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
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
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