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By Kim
Background
Shorting volatility proved to be very profitable historically. The reason is that VIX futures are drifting lower over time, so all you have to do is being short a product that is long volatility (like VXX) or being long an inverse product (like SVXY). Looking at VXX historical chart tells the whole story:
So what's the catch? Well, the issue with going short VXX (or being long SVXY) is those occasional big spikes, like the one in 2008. So the trick is to find a strategy that goes short VXX or long SVXY, but at the same time, doesn't lose much during those occasional spikes.
This article tells the story of an incredible SVXY trade that was a big winner despite the total collapse of SVXY.
Strategy Description
We will be looking to hold constant exposure to short volatility while the curve is in significant Contango in an effort to harvest volatility premium. We will also look to go long volatility when the curve is in significant Backwardation and indicators reveal the trend will continue in the short term. Because the curve is in Contango approximately 80% of the time, we will hold short exposure to volatility most of the time. The main strategy to gain this exposure will be through a Collar spread.
The PureVolatility model portfolio will be based on total capital amount of $10,000 with a 5% allocation on risk. This is very important as those who are trading in a Reg-T account would on average need $10,000 in initial margin to hold the position even though the risk may only be $500. Portfolio Margin accounts would only require the $500 max loss amount. Reg-T is somewhat antiquated when it comes to margin for a Collar spread. However, this really should not be an issue because if one does not have $10,000 to put aside for this strategy it is probably not appropriate. Furthermore, the increased margin amount will keep members from over allocating to this very aggressive strategy. We will target a risk reward of better than 1:1 for a two week holding period.
Here is an example of the Hedged Collar strategy sized for the model portfolio:
100 shares of SVXY at 101.93 Short 1 contract of the 11/10 110 Call at (1.35) Long 1 contract of the 11/10 103 Put at 5.54
Using the above example, here is the P/L chart of the trade:
Please note that the profit potential is around $400 and risk around $300.
For a strategy that wins around 80% of the time, this is an incredible risk/reward.
But it gets even better.
One of our other veteran members posted the following comment on the forum:
After some discussion, it has been decided to modify the trade and use deep ITM calls instead of the shares.
Here is an SVXY "modified" collar entered on January 30 with SVXY at 114:
P/L chart:
Please notice how using ITM calls instead of shares allows to reduce the risk if the stock makes a big down move.
The next day SVXY moved higher and short call has been added.
On February 2 SVXY started to move down. By the end of the day on February 5, SVXY went down around 40%. After few adjustments the P/L chart looked like this:
The trade was down $750 or 7.5% loss on $10,000. This is completely reasonable, considering that the underlying was down 40%. Any bounce to $90 area should bring the trade back to breakeven.
But then black Tuesday came. SVXY opened around $11, 60% down. The calls became nearly worthless, but the puts were the big winners, far outpacing the losses in the calls:
Overall this trade produced almost 45% gain on margin or 26% gain on $10,000 portfolio.
The bottom line:
A trade that was long SVXY, was a big winner after SVXY went down 90%+. This is options trading at its best. And this is the power of our trading community.
Read the full description of the PureVolatility strategy here.
Related articles:
The Astonishing Story Behind XIV Collapse The Incredible Option Trade In VXX The Lessons From The XIV Collapse The Spectacular Fall Of LJM Preservation And Growth
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By Michael C. Thomsett
A popular feature of spread selection is the assumption that mispriced options are found frequently. This observation leads to a natural conclusion, that is makes sense to take up a market position opposing the option while, at the same time, entering a position in the option. This popular hedge may involve trading in the underlying, or in other options that are equivalent to positions in the underlying. In this way, the volatility spread facilitates risk management while also exploiting a mispriced option.
Beginning with a study of delta, how can a trader hedge an underpriced option? There are several ways. If, for example, the first step is to buy 3 options, they can by hedged by: (a) selling 300 shares of the underlying, (b) buying puts with the same or similar delta, (c) selling calls of a different strike and with the same delta, or (d) combining the above moves in ways that create the same delta as the original long calls.
In setting up a volatility spread in one of several methods, the outcome creates several attributes that are shared by the strategies themselves. These include al overall delta neutral result, sensitivity to any price change in the underlying as well as to changes in implied volatility, and time decay that affects both sides of the spread equally (and based on amount of time remaining to expiration).
This last attribute, time decay, can lead to some interesting variations in the volatility spread when it is set up horizontally (different expirations) or diagonally (different expirations and strikes) rather than vertically (same expiration and strike). This adds great variety in how a volatility spread can be created. Among the consideration are collateral requirements, cost of the underlying when held or traded, and richness of premium on either long or short sides.
The selection of a volatility spread is complicated by the possibility of many different ones. The range of spreads includes:
Ratio backspreads (also called long ratio spreads) – combining a greater number of long options than short, with the sale expiration. The long positions should have higher delta value than the short positions. Either calls or puts can be used.
Ratio vertical spreads (also called front spreads or short ratio spreads) – This involves a higher number of short positions than long positions, all with the same expiration.
Butterfly and condor spreads, either long or short – unlike basic two-position spreads, butterfly and condor spreads involve more complex multiples, and may be either long or short. Butterflies involve three strikes, and condors use four.
Calendar spreads (horizontal or time spreads), long or short – the strikes are the same on both sides, but expiration is not. Typically, the shorter-term strikes are short and the longer-term are long. This exploits more rapid time decay on the short side, but it sets up a net debit.
Diagonal spreads (different expiration and strike) – in this variety, both strike and expiration are different. It is set up to exploit expected underlying movement as well as time decay. Shorter-term are normally short, and longer-term are long. By using different strikes, the net debit can be reduced or largely eliminated.
Ratio calendar or diagonal spreads – varying the number of positions in calendar or diagonal spreads allows an otherwise net debit to be converted to a net credit. Using shorter-term short options greater in number than longer-term long options, risks are manageable. Movement to ITM is managed by rolling forward and creating a different version of the volatility spread.
Collar – in this volatility spread, three positions are opened. They are a long position in the underlying, a short covered call, and a long put. The call’s strike is higher than the cost of the underlying, and the put’s strike is lower. This position makes sense when the original cost of the underlying was well below current market value.
Gut spread (both sides in the money) – this spread assumes the underlying will move significantly before option expiration, but the trader is not certain about the direct of the price movement.
Synthetic long and short stock – these consist of one long and one short option, which in combination mirror movement in the underlying security. A long stock synthetic consists of a long call and a short stock; and a short stock synthetic is made up of a long put and a short call. The net cost to open this position is close to zero if the strike is close to the money. The combined change in net value will track the underlying point for point. Given the many variations in the volatility spread, traders must be especially concerned with the degree of movement in the underlying. In the ideal hedge, the direction of underlying price change does not matter, because one side offsets the other. Most volatility spreads will perform better when movement takes place in a desired direction. But even in the perfect hedge, a large movement can create either exceptional profits or losses, as well as undesired changes in the collateral requirement.
This is especially concerning to traders using multiple contracts on either side, when a large underlying movement could outpace available capital, resulting in having part or all the position closed due to shortfalls in collateral. This may present a more serious risk than the option-related profitability of a spread. Even so, the unintended consequences that are always possible, may be overlooked by edging traders, or by those spending too much focus on delta and gamma and not enough on more basic matters, such as historical volatility.
Volatility spreads are appealing as hedging instruments, but they also come with many risks, including some not apparent when first considered. The trader who is aware of the importance of volatility in all spreads, is more likely to also be aware of a full range of risks.
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.
Related articles
Implied Volatility Collapse Pricing Models and Volatility Problems Types of Volatility Fundamental Volatility and Stock Prices How to Trade Options Volatility Volatility During Crises How To Profit From A Volatile Market -
By Kim
The study was done today - here is the link. The parameters of the study:
Use AAPL and GMCR as underlying. Buy a ATM straddle option 20 days before earnings. Sell it just before the announcement. The results of the study, based on 48 cycles (2009-2014)
AAPL P/L: -$2933 GMCR P/L: -$2070 Based on those results, they declared (once again) that buying a straddle before earnings is a losing strategy.
What's wrong with this study?
Dismissing the whole strategy based on two stocks is completely wrong. You could say that this strategy does not work for those two stocks. This would be a correct statement. Indeed, we do not use those two stocks for our straddles strategy. From our experience, entering 20 days before earnings is usually not the best time. On average, the ideal time to enter is around 5-10 days before earnings. This when the stocks experience the largest IV spike. But it is also different from stock to stock. The study does not account for gamma scalping. Which means that if the stock moves, you can adjust the strikes of the straddle or buy/sell stock against it. Many times the stock would move back and forward from the strike, allowing you to adjust several times. In addition, the study is probably based on end of day prices, and from our experience, the end of day price on the last day is usually near the day lows, and you have a chance to sell at higher prices earlier. The study completely ignores the straddle prices. We always look at prices before entering and compare them to previous cycles. Entering the right stocks at the right time at the right prices is what gives this strategy an edge. Not selecting random stocks, random timing and ignoring the prices.
As a side note, presenting the results as dollar P/L on one contract trade is meaningless. GMCR is trading around $150 today, and pre-earnings straddle options cost is around $1,500. In 2009, the stock was around $30, and pre-earnings straddle cost was around $500. Would you agree that 10% gain (or loss) on $1,500 trade is different than 10% gain (or loss) on $500 trade? The only thing that matters is percentage P/L, not dollar P/L.
Presenting dollar P/L could potentially severely skew the study. For example, what if most of the winners were when the stock was at $30-50 but most of the losers when the stock was around $100-150?
Tom Sosnoff and Tony Battista conclude the "study" by saying that "if anybody tells you that you should be buying volatility into earnings, they really haven't done their homework. It really doesn't work".
At SteadyOptions, buying pre-earnings straddle options is one of our key strategies. Check out our performance page for full results. As you can see from our results, the strategy works very well for us. We don't do studies, we do live trading, and our results are based on hundreds real trades.
Of course the devil is in the details. There are many moving parts to this strategy:
When to enter? Which stocks to use? How to manage the position? When to take profits? And much more.
So we will let tastytrade to do their "studies", and we will continue trading the strategy and make money from it. After all, as one of our members said, someone has to be on the other side of our trades. Actually, I would like to thank tastytrade for continuing providing us fresh supply of sellers for our strategy!
If you want to learn more how to use it (and many other profitable strategies):
Start Your Free Trial
Related Articles:
How We Trade Straddle Option Strategy
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
Long Straddle: A Guaranteed Win?
How We Made 23% On QIHU Straddle In 4 Hours
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By Kim
As a reminder, a strangle involves buying calls and puts on the same stock with different strikes. Buying calls and puts with the same strike is called a long straddle. Strangles usually provide better leverage in case the stock moves significantly.
So let’s see how it works. First, you must identify stocks which have a history of big post-earnings moves. Some examples include AMZN, Netflix, Google, Priceline (PCLN), and others. Then you buy a strangle or a straddle a day or two before the earnings are announced. If the stock has a big move, you sell for a big profit.
The problem is you are not the only one knowing that earnings are coming. Everyone knows that those stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper.
Let’s examine a few test cases from the 2011 earnings cycle.
AKAM announced earnings on Oct. 26. The $24 straddle could be purchased for $4.08. IV was 84%. The next day the stock jumped 15%, yet the straddle was worth only $3.81. The reason? IV collapsed to 47%. The market “expected” the stock to move 17-18%, based on previous moves, but the stock moved “only” 15% and the straddle lost 7%. BIDU announced earnings on Oct. 26. The stock moved 4.5% following the earnings. You could purchase the straddle at $19.55 the day before earnings. The same straddle was worth $13.47 the next day. That’s a loss of 31%. TIVO moved 2%, the straddle lost 29%. FSLR moved 3%, the straddle lost 55%. Now let’s check a couple of good trades.
NFLX announced earnings on October 24. The stock collapsed 34.9% the next day, a move of historical proportions. The 120 strangle could be purchased the day before earnings at $24.52 and sold the next day at $43.00. That’s a 75% gain, but this is as good as it gets. This is a move of historic proportions but the trade is even not a double. AMZN straddle gained 57%. CME straddle gained 62%. GMCR straddle gained 84%. It is easy to get excited after a few trades like NFLX, GMCR, CME and AMZN. However, we have to remember that those stocks experienced much larger moves than their average move in the last few cycles. In some cases, the move was double what was expected. NFLX and GMCR moved more than 35%, the largest moves in at least 10 years. Chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit.
Some people might argue that if the trade is not profitable the same day, you can continue holding or selling only the winning side till the stock moves in the right direction. It can work under certain conditions. For example, if you followed the specific stock in the last few cycles and noticed some patterns, such as the stock continuously moving in the same direction for a few days after beating the estimates. Another example is holding the calls when the general market is in uptrend (or downtrend for the puts).
However, it has nothing to do with the original strategy. From the minute you decide to hold that trade, you are no longer using the original strategy. If the stock didn’t move enough to generate a profit, you must be ready to make a judgement call by selling one side and taking a directional bet. This might work for some people, but the pure performance of the strategy can be measured only by looking at a one day change of the strangle or the straddle (buying a day before earnings, selling the next day).
The bottom line:
Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.
Jeff Augen, a successful options trader and author of six books, agrees:
It doesn’t necessarily mean that the strategy cannot work and produce great results. However, in most cases, you should be prepared to hold beyond the earnings day, in which case the performance will be impacted by many other factors, such as your trading skills, general market conditions etc.
To hedge your bets and reduce the loss if the stock doesn't move, you might consider trading a Reverse Iron Condor.
This article was originally published here.
Related articles:
How We Trade Straddle Option Strategy Exploiting Earnings Associated Rising Volatility Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? Long Straddle: A Guaranteed Win? Straddle, Strangle Or Reverse Iron Condor (RIC)? How We Made 23% On QIHU Straddle In 4 Hours Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings How To Calculate ROI On Credit Spreads Straddle Option Overview Long Straddle Through Earnings Backtest Straddles - Risks Determine When They Are Best Used The Gut Strangle Long And Short Straddles: Opposite Structures -
By Kim
However, not all stocks are suitable for that strategy. Some stocks experience consistent pattern of losses when buying premium before earnings. For those stocks we are using some alternative strategies like calendars.
In one of my previous articles I described a study done by tastytrade, claiming that buying premium before earnings does not work. Let's leave aside the fact that the study was severely flawed and skewed by buying "future ATM straddle" which simply doesn't make sense (see the article for full details). Today I want to talk about the stocks they used in the study: TSLA, LNKD, NFLX, AAPL, GOOG.
Those stocks are among the worst candidates for a straddle option strategy. In fact, they are so bad that they became our best candidates for a calendar spread strategy (which is basically the opposite of a straddle strategy). Here are our results from trading those stocks in the recent cycles:
TSLA: +28%, +31%, +37%, +26%, +26%, +23% LNKD: +30%, +5%, +40%, +33% NFLX: +10%, +20%, +30%, +16%, +30%, +32%, +18% GOOG: +33%, +33%, +50%, -7%, +26%
You read this right: 21 winners, only one small loser.
This cycle was no exception: all four trades were winners, with average gain of 25.2%.
I'm not sure if tastytrade used those stocks on purpose to reach the conclusion they wanted to reach, but the fact remains. To do a reliable study, it is not enough to take a random list of stocks and reach a conclusion that a strategy doesn't work.
At SteadyOptions we spend hundreds of hours of backtesting to find the best parameters for our trades:
Which strategy is suitable for which stocks? When is the optimal time to enter? How to manage the position? When to take profits?
The results speak for themselves. We booked 147% ROI in 2014 and 32% ROI so far in 2015. All results are based on real trades, not some kind of hypothetical or backtested random study.
Related Articles:
How We Trade Straddle Option Strategy
How We Trade Calendar Spreads
Buying Premium Prior to Earnings
Can We Profit From Volatility Expansion into Earnings
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
The Less Risky Way To Trade TSLA
If you want to learn more how to use our profitable strategies and increase your odds:
Start Your Free Trial
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By Kim
About six months ago, I came across an excellent book by Jeff Augen, “The Volatility Edge in Options Trading”. One of the strategies described in the book is called “Exploiting Earnings - Associated Rising Volatility”. Here is how it works:
Find a stock with a history of big post-earnings moves. Buy a strangle for this stock about 7-14 days before earnings. Sell just before the earnings are announced. For those not familiar with the strangle strategy, it involves buying calls and puts on the same stock with different strikes. If you want the trade to be neutral and not directional, you structure the trade in a way that calls and puts are the same distance from the underlying price. For example, with Amazon (NASDAQ:AMZN) trading at $190, you could buy $200 calls and $180 puts.
IV (Implied Volatility) usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes.
Like every strategy, the devil is in details. The following questions need to be answered:
Which stocks should be used? I tend to trade stocks with post-earnings moves of at least 5-7% in the last four earnings cycles; the larger the move the better. When to buy? IV starts to rise as early as three weeks before earnings for some stocks and just a few days before earnings for others. Buy too early and negative theta will kill the trade. Buy too late and you might miss the big portion of the IV increase. I found that 5-7 days usually works the best. Which strikes to buy? If you go far OTM (Out of The Money), you get big gains if the stock moves before earnings. But if the stock doesn’t move, closer to the money strikes might be a better choice. Since I don’t know in advance if the stock will move, I found deltas in the 20-30 range to be a good compromise. The selection of the stocks is very important to the success of the strategy. The following simple steps will help with the selection:
Click here. Filter stocks with movement greater than 5% in the last 3 earnings. For each stock in the list, check if the options are liquid enough. Using those simple steps, I compiled a list of almost 100 stocks which fit the criteria. Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Netflix (NASDAQ:NFLX), F5 Networks (NASDAQ:FFIV), Priceline (PCLN), Amazon (AMZN), First Solar (NASDAQ:FSLR), Green Mountain Coffee Roasters (NASDAQ:GMCR), Akamai Technologies (NASDAQ:AKAM), Intuitive Surgical (NASDAQ:ISRG), Saleforce (NYSE:CRM), Wynn Resorts (NASDAQ:WYNN), Baidu (NASDAQ:BIDU) are among the best candidates for this strategy. Those stocks usually experience the largest pre-earnings IV spikes.
So I started using this strategy in July. The results so far are promising. Average gains have been around 10-12% per trade, with an average holding period of 5-7 days. That might not sound like much, but consider this: you can make about 20 such trades per month. If you allocate just 5% per trade, you earn 20*10%*0.05=10% return per month on the whole account while risking only 25-30% (5-6 trades open at any given time). Does it look better now?
Under normal conditions, a strangle trade requires a big and quick move in the underlying. If the move doesn’t happen, the negative theta will kill the trade. In case of the pre-earnings strangle, the negative theta is neutralized, at least partially, by increasing IV. In some cases, the theta is larger than the IV increase and the trade is a loser. However, the losses in most cases are relatively small. Typical loss is around 10-15%, in some rare cases it might reach 25-30%. But the winners far outpace the losers and the strategy is overall profitable.
Market environment also plays a role in the strategy performance. The strategy performs the best in a volatile environment when stocks move a lot. If none of the stocks move, most of the trades would be around breakeven or small losers. Fortunately, over time, stocks do move. In fact, big chunk of the gains come from stock movement and not IV increases. The IV increase just helps the trade not to lose in case the stock doesn’t move.
In the next article I will explain why, in my opinion, it usually doesn’t pay to hold through earnings. We always close those trade before earnings to avoid IV crush.
The original article was published here.
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By Michael C. Thomsett
Because the public cannot trade options after Friday’s close, speculating on these positions must assume that price will move after last trading day but before Saturday expiration. Traders have no control over this, meaning it is taking a chance, whether going long or short.
With volatility collapse a factor in how price behaves on expiration Saturday, the question becomes whether it changes rapidly or smoothly – or not at all. Because it is unlikely that high volatility will be likely to decline smoothly, most traders will not want the exposure, especially when taking short positions. It may be reasonable if the price is low enough to speculate in a long call or put, hoping that volatility moves in a favorable direction.
Experienced traders will observe a predictable pattern in volatility collapse on last trading day, and this helps select a position that offers a better than average likelihood of profit. However, the profile is determined by volatility in the underling and will not be the same for all stocks. As with all option strategies, timing of last-minute trades based on volatility collapse must be done with familiarity of the underlying and its historical volatility. This assumes that implied volatility will closely follow that trend. It normally does, but given that expiration is about to occur, this is not always going to occur as expected.
If the analysis is limited at ATM options on last trading day, it should be kept in mind that these positions are overly sensitive to even the smallest change in the underlying price, notably in the final hours of trading. Because this takes place on Friday, even non-option stock traders behave with full awareness that they will not be able to trade for three days. This affects potential value of both the stock and its options. Implied volatility in this timing is going to be noisy in the sense it will be more volatile than usual. This may be an advantage or a disadvantage, based on many factors. Most option traders are fully aware of most of these factors.
Complicating matters even more, market behavior is not going to be rational in all cases, especially on expiration Friday (for option traders) and to a degree, on any Friday (for equity traders). This irrational behavior makes implied volatility noise even more intense than a trader might expect. A blind spot for many traders is the assumption that trading decision are made rationally, and this can lead to problems in timing.
Implied volatility must be expected to become increasingly unreliable and unpredictable for ITM options, and for many last-minute traders, ITM options are the preferred vehicle for trades. A related observation worth making is the reliability and stability of calls and puts in this moment. Because only one of the two will be ITM, it is likely that one side (ITM) will be unpredictable, while the other side (OTM) will be more predictable. This raises some interesting possibilities for last-minute spread trading, with emphasis on OTM positions as offering less risk, and ITM positions possibly presenting more profit (or loss).
Also affecting the potential profit or loss based on moneyness, is the pinning factor. If the underlying will move toward (or remain at) a price close to the strike of the closest option, how does this affect the timing of expiration trading? Pinning, like implied volatility, is not as predictable as traders would like, but it could be a factor. Some traders believe that option behavior can and does affect underlying prices. But this is only true in that very short-term time right near expiration, and not during the entire cycle. Trading on the assumption of how implied volatility will behave, tied into an assumption about price pinning, is a dangerous and often expensive strategy.
Most traders would not consider expiration trading as a form of equity hedging. However, it is possible to time option positions to protect equity profits (with covered calls, for example), representing a short-term hedge. For example, if the stock position is profitable, a covered call can be opened on last trading day ITM. If the underlying price moves above the strike, exercise produces a profit from both the equity investment and the option premium. If the underling price declines, the loss is reduced due to option premium, taking net basis down; and this further allows the trader to enter another covered call or similar position. Because expiration strategy does not allow traders to close or roll after Friday’s close, entering a similar hedge with a short put is not as wise. ITM expiration means unavoidable exercise, and most short put writers do not want exercise of the position. The short put strategy has the same market risk as a covered call, but at expiration, it is not as safe. A covered call is going to be advantageous whether underlying price rises or falls. This is not true with short puts.
In entering any option position, the assumed volatility collapse will occur in a predictable manner, but the speed and degree of movement toward zero is not the same in every case. This is where the interesting potential is found, either for profit or loss. Implied volatility for high-volume stocks will behave much differently for low-volatility issues. But even this does not mean the speed and degree of change is going to be predictable; it might, in fact, behave as irrationally as those traders in the market at this last step in the option’s lifespan.
Perhaps the most interesting selection for expiration trading is the case where earnings announcements are made after Friday’s close. In this case, public trading is no longer possible, but volatility could change significantly by the end of expiration Saturday. The trader’s dilemma in this case is that a big earnings surprise could be either positive or negative. Anyone speculating on this situation must be ready to accept a loss if the surprise is not a pleasant or desirable one.
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.
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By Kim
However, panicking during volatile conditions is the last thing you want to do. To an extent, volatility can even play to your favor as a trader.
Volatility: Causes and Effects
Volatility is simply explained as the severity and frequency of change in the value of an asset over a certain period of time. It is mostly associated with the stock market but it also applies to different markets, such as foreign exchange or commodities. Regardless, a market with low volatility means there isn’t much change in the price of an asset, certainly not enough to stir a panic. High volatility, on the other hand, indicates wide price fluctuations and heightened risk for investors.
Volatility occurs when there is an imbalance of trade orders. Panic selling, for example, can trigger a sharp decline in stock prices, while panic buying can cause prices to shoot through the roof. What causes volatility, then, is the sentiment of investors that leads them to behave in a certain manner. This is influenced by a couple of factors, including economic and socio-political developments. Announcements from the central bank, inflation, and elections fall under this category. Company developments also influence the value of a certain stock. A change in corporate leadership or announcements of a new product can trigger investors to take a bullish or a bearish view on the asset.
High volatility also has negative effects on the trading process as well. Because of the high volume of trading, execution of orders might be delayed. Actual prices might vary from the quoted prices from when the order was placed due to the delay in execution. Or worse, high trading activity might make it difficult to place trades in a timely fashion or even access online trading accounts. To prevent these from happening, the U.S. stock exchanges set up circuit breakers to temporarily pause trading activity during turbulent times. This happened several times in March as investors panicked over the coronavirus outbreak which fuelled market volatility.
Taking advantage of volatility
That said, volatility isn’t necessarily something to fear. In fact, any trader with enough experience will tell you that price movements, whether positive or negative, present more opportunities to turn a profit. This is especially true for short-term traders like day traders or swing traders who take advantage of price fluctuations. Risk moves in both directions — while volatility might mean a greater potential for loss, it can also magnify the potential for rewards. Of course, the key is making an accurate prediction of how an asset’s price will move. Short-term traders who bet on price swings use different volatility indicators to determine the best position for their trade. These indicators let investors properly time market highs and lows so they can enter and exit as necessary. Or, it can also be used to justify shorting a stock or as a hedging strategy.
Another way to take advantage of market volatility is to trade derivatives instead of the underlying asset. Stock CFD trading, or trading contracts for difference, allow you to speculate on stock share prices regardless if it’s an uptrend or downtrend. For instance, instead of risking exposure in a falling market, you can profit from CFD trading by speculating on the downtrend using volatility indicators. Trading options is another way to use volatility in your favor over shorter periods of time.
Whether you’re trading the primary asset or its derivative, it’s important to understand that market volatility is an inevitable part of trading. For short-term traders, it’s actually a welcome component because stagnant prices limit the potential to generate profit. But if you’re taking a long-term approach by investing, avoid panicking in turbulent conditions. Continuously review your risk tolerance and rebalance your portfolio, while also getting comfortable with riding out highs and lows.
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By Kim
Here is how their methodology works:
In theory, if you knew exactly what price a stock would be immediately before earnings, you could purchase the corresponding straddle a number of days beforehand. To test this, we looked at the past 4 earnings cycles in 5 different stocks. We recorded the closing price of each stock immediately before the earnings announcement. We then went back 14 days and purchased the straddle using the strikes recorded on the close prior to earnings. We closed those positions immediately before earnings were to be reported.
Study Parameters:
TSLA, LNKD, NFLX, AAPL, GOOG Past 4 earnings cycles 14 days prior to earnings - purchased future ATM straddle Sold positions on the close before earnings
The results:
Future ATM straddle produced average ROC of -19%.
As an example:
In the previous cycle, TSLA was trading around $219 two weeks before earnings. The stock closed around $201 a day before earnings. According to tastytrade methodology, they would buy the 200 straddle 2 weeks before earnings. They claim that this is the best case scenario for buying pre-earnings straddles.
My Rebuttal
Wait a minute.. This is a straddle, not a calendar. For a calendar, the stock has to trade as close to the strike as possible to realize the maximum gain. For a straddle, it's exactly the opposite:
When you buy a straddle, you want the stock to move away from your strike, not towards the strike. You LOSE the maximum amount of money if the stock moves to the strike.
In case of TSLA, if you wanted to trade pre-earnings straddle 2 weeks before earnings when the stock was at $219, you would purchase the 220 straddle, not 200 straddle. If you do that, you start delta neutral and have some gamma gains when the stock moves to $200. But if you start with 200 straddle, your initial setup is delta positive, while you know that the stock will move against you.
It still does not guarantee that the straddle will be profitable. You need to select the best timing (usually 5-7 days, not 14 days) and select the stocks carefully (some stocks are better candidates than others). But using tastytrade methodology would GUARANTEE that the strategy will lose money 90% of the time. It almost feels like they deliberately used those parameters to reach the conclusion they wanted.
As a side note, the five stocks they selected for the study are among the worst possible candidates for this strategy. It almost feels like they selected the worst possible parameters in terms of strike, timing and stocks, in order to reach the conclusion they wanted to reach.
At SteadyOptions, buying pre-earnings straddles is one of our key strategies. It works very well for us. Check out our performance page for full results. As you can see from our results, "Buying Premium Prior To Earnings" is still alive and kicking. Not exactly "Nail In The Coffin".
Comment: the segment has been removed from tastytrade website, which shows that they realized how absurd it was. We linked to the YouTube video which is still there.
Of course the devil is in the details. There are many moving parts to this strategy:
When to enter? Which stocks to use? How to manage the position? When to take profits?
And much more. But overall, this strategy has been working very well for us. If you want to learn more how to use it (and many other profitable strategies):
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By Kim
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 long 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 crushes 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 options trading 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.”
Related Articles:
How We Trade Straddle Option Strategy Buying Premium Prior to Earnings Can We Profit From Volatility Expansion into Earnings Long Straddle: A Guaranteed Win?
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