Thoughts about a strategy of holding LNKD through earnings July 2015

[Vancouver 54]

As we all know, holding a calendar spread through earnings is an extremely risky strategy. It can work extremely well, if the underlying doesn't move much, but can result in a loss north of 80% quite quickly when the stock is making a major move. Since we can only guess what will be a move in a given quarter, holding a "naked calendar" isn't a good strategy, just a bet that you can sometimes win.

At the same time, I believe that in certain conditions, coupled with an additional strategy, holding through earnings may actually be something to consider.

 

LNKD is reporting tomorrow (July 30) after the close.

The 3-week spreads that we have been trading have reached ridiculously low values when compared historically.

For example, I entered the ATM 3-week spread (P227.5) today for $1.27. In some previous cycles a similar 3-week spread had cost more than $2.00. The reason the spread is so cheap is because the IV on the short leg is around 196 (!!) today, while the IV on the long leg is only 63 or so. Clearly, option players are betting on a large move (maybe given recent moves in AMZN, TWTR, NFLX etc.) and pumping up premiums of the shortest expiration (our July 31 short leg).

 

The historical IV level of LNKD is around 30. Once earnings are announced IV will collapse, but of course won't reach 30 immediately. The short leg will keep IV elevated for a while and it will decrease as the day progresses - note that for the short leg (July 31) there is only one trading day after earnings - Friday, July 31. 

The long leg (August 21) will see its IV collapsing to at least 40 on Friday morning, and probably continue to decline during the trading day.

 

For my little example, I calculated the theoretical values of the short and long legs after earnings (Friday morning) assuming that the IV in the short leg came down to 50 from 195 (50 is still very high), and to 30 from 63 for the long leg (crushing all the way to 30 in the first day after earnings is unlikely). These are very conservative assumptions, but I want to be conservative.

Given these assumptions, see below the value of our 3-week Put spread for different strikes on Friday morning:

 

Strike

3-week Put spread

205

0,46

207,5

0,62

210

0,90

212,5

1,23

215

1,54

217,5

2,01

220

2,52

222,5

2,89

225

3,34

227,5

3,76

230

3,88

232,5

3,90

235

3,92

237,5

3,67

240

3,27

242,5

2,92

245

2,54

247,5

2,08

250

1,63

252,5

1,36

255

1,06

257,5

0,76

260

0,58

 

Assuming we entered the trade ATM at the current price of $1.30 or so, based on this table as long as the stock is staying in the range 212.50 - 252.50 (about 20 points move in each direction or 9%) we should be fine. If the stock doesn't move at all, the spread value should be worth around $4.00. But if the stock is making a larger move, the position will start losing money quickly.

 

So my proposal is to couple up the spread with two July 31 long spreads - calls and puts.

For example, with the stock currently at $232.50, we can buy the July Call 245 (long) - 275 (short) spread for $6.00 and the 220 (long) - 190 (short) spread for $7. Jointly paying $13, which is about 10% of the price of the ATM 3-week, spread. So we will need a ratio of 10:1 between the calendar spreads we have and the long call and put spreads.

 

Under this strategy, the worst points for the stock to open on Friday morning would be the break-even points of the spreads $252.50 and 212.50. In this case, the calendar spreads will break even and the joint value of the long calls and puts will be worth probably around $10-$11 (purchased at $13). So the "soft spot" of the trade is between $252.50-$257.50 and $212.50-$207.50). Any other value will produce nice gains that can be at least 50% if the stock doesn't move much, or if the stock moves a lot.

 

Also, don't forget that I used extremely conservative assumptions for the IV crush, so spreads values should be much higher an hour or two into trading on Friday.

 

My plan is to try to sell the spread I bought today at $1.70 or more tomorrow, and if I can't get this price, pair it up with call and put spreads and hold through earnings.

 

Any comments would be highly appreciated! 

[Edwin 63]

Here's the revised P/L:

Long 7 3-week Call 252.50 spread @ $1.30

Long 7 3-week Put 212.50 spread @ $1.05

Long 1 July 31 Call vertical spread – long Call 260, short Call 290 @ $2.92

Long 1 July 31 Put vertical spread – long Put 205, short Put 175 @ $3.23

Edited July 30, 2015 by edboc

[MichiganWater 11]

This is very interesting.  Would you be willing to share how you calculated the various outputs?  I'd like to do the calculations myself, but I don't know if I have the tools available to do so.  Can these be implemented in a spreadsheet, or programmed in R?

 

Let's say the stock skyrockets to the point where the calendars are worth essentially 0.  At that point the put vertical is also worth 0 and the call vertical is worth $30.  Then, given an initial investment of $26 ($13 from 10 calendars, $13 from the call vertical and put vertical), the net profit will be $30 - $26 = $4.00.  Same thing if the stock plummets so much that the calendars and call verticals are worth 0 and the put vertical is worth $30.  Is that correct?

[Yowster 9,155]

Vancouver,

 

Very interesting, and I agree with you stats with a quick look over the trade.  It will be interesting to see how this plays out.   When figuring the break-even for the long call and put spreads, I would typically use the +/- $13 to calculate the break-evens for these spreads since they were purchased together (ie. don't use the cost of the individual spreads).  Note that using the +/-13 winds up right at the soft spots that you outlined.

 

Practically speaking, right after earnings on Friday morning expect the option bid/ask spreads to be very wide.  This is typical post-earnings behavior and it usually takes an hour of so for the bid/ask spreads to shrink down.  This means mid point pricing will jump around like crazy first thing on Friday morning and it may affect your ability to close near mid points early in the day.

[verbotenstylen 6]

Did you also remember to knock down the vol of the vert spreads as well?  That would make a big difference in the p/l after the vol crush.

[Vancouver 54]

Yes, this is correct. $4 will be the profit is the stock crushes or sky rocket. This translates to a 15% gain. It is still a decent gain, but mostly serves a s a hedge as THE major concern with holding a calendar through earnings is a major move in the stock.

The strategy would be much more profitable if the move is lower than expected implied move, and will top if the stock doesn't move at all.

 

BTW, I use OptionsXpress to calculate theoretical values, but one should be able to find many option calculators online.

[Vancouver 54]

Ideally, I wouldn't like to close the trade in the first 2-3 hours on Friday. The reason is that once the price of LNKD stabilizes, the IV of the short leg will collapse at a very high pace. With such a huge difference between the IV of the short and long (195 vs. 63), this will play in the favour of the trade.

In my theoretical values I used IV of 50 for the short leg. This of course wouldn't be the case for the entire day.

But if the stocks opens with a small move +- $5, I would like to take advantage and lock the profits right a way.

[Edwin 63]

Let us know the results and outcome.

[Yowster 9,155]

ebdoc - I don't think your P&L chart is correct in that the trade should show a profit with a huge move up or down.  What should be charted is a combo of (of course taking IV drop into account):

• 10 ATM (232.50 strike) calendars long July31 and short Aug21
• 1 July31 call debit spread - long 245 strike and short 275 strike
• 1 July31 put debit spread - long 220 strike and short 190 strike

[Kim 7,943]

There are a lot of moving parts here. But I'm not sure I like the risk/reward. Here is the problem:

 

The biggest gain will be realized around 230. But the chance that the stock will remain around 230 is extremely small. So lets ignore this scenario. The best case scenario is probably the stock above 275 or below 190. In this case, the calendar will be almost worthless and one of the verticals will be worth $30 (the second will be worthless). So you invest 2600 (10 calendars at 1.30 and two verticals) and your maximum gain is 15%. But those levels represent 20% move. The stock moved 20% only once (last cycle) rest of the time it moved around 12-15%. The implied move is $27, so 257/203, and this is where the weak spot of this trade is. In case it is around the weak spot, the loss can be around 20-40%. 

 

As you can see, the risk/reward is not necessarily favorable, and is also very difficult to calculate. 

[Yowster 9,155]

ebdoc - regarding your question on why 10 calendars:  Vancouver came up with that ratio based on the cost of the calendar spread ($1.30) compared to the cost of the two debit spreads ($13).  The 10-to-1 ratio is so that the capital invested in each part of the trade is the same.

[Vancouver 54]

Thanks all for your feedback!

Kim, here are a few responses to your comments:

 

1. I wouldn't just dismiss the likelihood of a small move in the stock. Indeed, in the available history we have for LNKD (16 reports since it went public) the average move was 10.85%, and it was only once 0%. It was never less than 6.2% since 2013. But all is possible, and the stock has seen small moves of 4%, 5% and 6%. In addition, big options writers who sell rich premiums have a strong incentive to keep the move small.

 

2. Every strategy has weak spots. If not, it would be an arbitrage and the market will eliminate it reasonably fast. Our calendar spreads that we trade so successfully also have their weak spots (large moves in the underlying / a sudden increase in the IV of the short leg, etc. ) but we try to minimize them by entering at what we believe is a good entry price, and by trading many times such that on average we have a winning ratio. I believe that when the gap in IV between the sort leg and the long leg is so huge as it is now for LNKD 195 vs. 63), calendar spreads are just too cheap, and there is got to be away to make money (on average) by buying them, coupled with a reversed Iron Condor or a straddle.

 

3. But on the other hand, why fight the facts. If we believe that a small move is very unlikely, we can move the heart of the strategy from ATM calendars to OTM calendars. That is, instead of buying 10 ATM puts, we can buy 5 OTM Calls/Puts at spot +9%, and 5 OTM Calls/Puts at spot -9%. Simply split the 10 calendars to 5 and 5, with strikes at 252.50, and 212.50. There are a few advantages for that: First, if think a very small move, say up to 4% is extremely unlikely, why fight it. Second, the price of the calendars is lower; spreads are very wide now but the average price of the put/call 212.50 strike is $1.05, and that of the 252.50 strike is $1.30. So the average cost is lower at $1.17. Third, the profit tent is much wider now, so we will need to spend less on buying the reversed Iron Condor to protect against a large move. In fact, if we pay $1.17 on average for the 3-week calendars (5+5), these will be profitable (jointly) at any strike between 200 and 265. Now we’re covered against a 14% move.

 

3. If we buy a protection against a move larger than 14% it will create a weak spot around the current stock price +-3-4%. One option will be to buy the following two verticals: long Call 260, short Call 290 for $2.92, and long Put 205, short Put 175 for $3.23, we are paying jointly $6.15. In this case, I believe a ratio of 1:14 (instead of 1:10 in my previous example) between the calendar spreads and the reversed Iron Condor would be sufficient.

 

4. To summarize the strategy will be the following:

 

Long 7 3-week Call 252.50 spread @ $1.30

Long 7 3-week Put 212.50 spread @ $1.05

Long 1 July 31 Call vertical spread – long Call 260, short Call 290 @ $2.92

Long 1 July 31 Put vertical spread – long Put 205, short Put 175 @ $3.23

 

Total cost: $22.60

 

This still needs fine tuning, but the weak spot of the trade is now ATM +- 2-3%. Elsewhere, it’s going to be profitable.

Maybe that is the way to go.

I would appreciate your comments.

[Kim 7,943]

I don't completely dismiss the likelihood of a small move in the stock. I just think it's unlikely, and we are playing probabilities.

 

Again, I'm not saying it cannot work. But it seems a bit too complicated, with a lot of moving parts. Personally I just prefer to close it. Right now it shows ~10% loss, will try to close around breakeven.

[daviddream 23]

What a great education I am getting on this site. I will virtually trade this setup to see how it goes. Keep us informed Vancouver! 

[daviddream 23]

By the way, I am out of the trade with around-11% and a boatload of commissions. Options House is happy!

[deblina1981 2]

@Vancouver, do you think the 200P or 230P calenders will be really worth ~4.00 if LNKD does not move much, since I did not see a similar price increase for FB ATM spreads (it is roughly double the value ~1.50/spread) when FB did not move. I do understand that there is a difference of volatility between the weekly and front month for the two tickers.

[Vancouver 54]

Ok, here is the setup I opened with the stock at $225:

 

Long 7 3-week Call 245 spread @ $1.48

Long 7 3-week Put 205 spread @ $1.16

Long 1 July 31 Call vertical spread – long Call 255, short Call 285 @ $2.83

Long 1 July 31 Put vertical spread – long Put 205, short Put 175 @ $3.01

 

Total cost: $24.32

 

I decided to go with Call 245 and Put 212.5, so if the move is between those strikes, I won't be forced to sell one of the spreads and can simply let the short legs expire worthless. Also, if there is a huge move, selling deep in the money spread may be tricky. So I paid more than I planned for the 245 Call calendar, but it'll make my life easier.

 

Let's how this is played tomorrow. I will report. 

[Vancouver 54]

30 minutes before the close, prices are the following:

 

Long 7 3-week Call 245 spread @ $1.95

Long 7 3-week Put 205 spread @ $1.25

Long 1 July 31 Call vertical spread – long Call 255, short Call 285 @ $2.88

Long 1 July 31 Put vertical spread – long Put 205, short Put 175 @ $4.92

 

Total current value: $30.20 (25% higher than cost). 

[Vancouver 54]

Sorry typo, I actually bought the long Put 200, short Put 170 @ $3.01 (and not the 205-175 reported above).

So this is the strategy to follow for tomorrow:

 

Long 7 3-week Call 245 spread @ $1.48

Long 7 3-week Put 205 spread @ $1.16

Long 1 July 31 Call vertical spread – long Call 255, short Call 285 @ $2.83

Long 1 July 31 Put vertical spread – long Put 200, short Put 170) @ $3.01

 

Total cost: $24.32

[Vancouver 54]

The stock is trading around $250 after hours. An 11% move similar to the IM and what Kim predicted. This would be perfect as an opening price tomorrow, but of course it is too early to know. In any case, I'm happy that I moved the heart of the strategy +-10%. 

[kdawg 0]

Wow, down 3% to $225 now

[Vancouver 54]

Just wanted to say that I'm posting my ideas and live experience on this blog in order to share it and learn from members of our community. I'm not trying to lure anyone to invest irresponsibly or anything like that. A few members of our community had posts today saying they are holding the 220P 3-week calendar through earnings, out of frustration, as they couldn't sell it for a reasonable price. I would be TOTALLY against that. Making desperate moves out of frustration is the one thing that will - with certainty - make you lose all your capital in the long run. Yes, it is likely that LNKD will open around 215-220 tomorrow and the spread will be worth north of $3.50. Those who held it overnight will feel smart as they just tripled their money compared to selling it last minute on Thursday. But an isolated success like this will simply plant the seeds to making more irresponsible investment decisions in the future that eventually will result in big losses. You can be lucky a few times, but when the odds are against you, you will lose in the long run. Trust me, I've been there.

 

The strategy I proposed is to try to take advantage of the temporary mispricing in the 3-week calendars, and come up with a strategy that will be profitable with high likelihood but of course not with 100% certainty. I eliminated the very big upside by spreading my investments to cover ALL price ranges for LNKD tomorrow. But that's ok, as it makes it a responsible/reasonable investment as oppose to a wild bet. The strategy I proposed is somewhat difficult to implement, so if you're not extremely comfortable with trading options I wouldn't recommend it at all. But as part of our joint learning process on this blog, I hope it can be useful for many of us.

[daviddream 23]

That is why virtual trading is always preferable when learning complicated stuff. I did the same trade virtually just to watch the effects on each portion of the trade. 

[Chuck451 310]

Vancouver, I for one would like to thank you for posting your ideas and offering them to those of us that are rookie option traders.  I find them all very educational and look forward to your next ideas.

 

Keep it up!

[Kim 7,943]

Vancouver, your posts are highly appreciated. I couldn't say it better.

 

And btw, what you wrote about sharing ideas is correct regarding my posts as well. They are not trade recommendations, they are trading ideas that I share with members so everyone can make his own decisions.

 

​Your trade seems to be working fine so far? But getting out might be challenging.

[daviddream 23]

Kim, It's funny you're speaking of getting out a complicated trade like this one. I tried to exit legs on my virtual trade and there were no takers, so I finally gave up. 

[Kim 7,943]

Kim, It's funny you're speaking of getting out a complicated trade like this one. I tried to exit legs on my virtual trade and there were no takers, so I finally gave up. 

Well, this is why I hesitate to do those trades. First, two many moving parts, and many times you will need to get out from few parts at the same time. Second, spreads are usually huge at the first hour, and even if you have a gain, it might be difficult to realize. And by the time the spreads normalize, the stock can move.

 

It will be interesting to see real results of this trade.

[Vancouver 54]

Current prices as of 10:00

 

Long 7 3-week Call 245 spread @ $0.18

Long 7 3-week Put 205 spread @ $3.70

Long 1 July 31 Call vertical spread – long Call 255, short Call 285 @ $0.00

Long 1 July 31 Put vertical spread – long Put 200, short Put 170) @ $0.91

 

Total value: $28.07 (+15% gain).

 

The question is how to proceed here.

The IV of the August 21 long leg collapsed to 33.

The P205 spread which is the most valuable part of the strategy will increase in value as the day progresses since the short leg which expires today will converge to zero if the stock stays around $205. Currently, the short leg is worth $2.85 or so, in this entire premium will evaporate.

At the same time, the IV of the long leg probably will go down a bit more through the day.

So if the stock ends at $205 this afternoon, the spread will be worth around $6.00

 

Because all July 31 legs will converge to their intrinsic value, even if the stock moves +- $5 from 205, the long leg will still increase in value, but if a larger move occurs, the price will go down below the current $3.70 level.

I will probably close it soon.

[Vancouver 54]

Out of the position:

 

Long 7 3-week Call 245 spread @ $0.13

Long 7 3-week Put 205 spread @ $3.88

Long 1 July 31 Call vertical spread – long Call 255, short Call 285 @ $0.00

Long 1 July 31 Put vertical spread – long Put 200, short Put 170) @ $0.79

 

Total value: $28.86 (+18.9% gain)

[Yowster 9,155]

Vancouver - Thanks for the analysis. I know you investigated this trade and opened it because of the poor LNKD calendar performance.  But it may be a lower risk way to play high IV stocks holding thru earnings.   A question for you - based on how the options are priced after earnings, what would have been your worst case loss with this trade, if LNKD price wound up at the worst strike for your trade?

[daviddream 23]

Good work! Was that 18% before commissions?

[4REAL 110]

Hey Vancouver,

Congrats

 

And thanks for sharing your (as always) highly appreciated trade ideas

Edited July 31, 2015 by 4REAL

[PaulCao 51]

Hi Vancouver, 

 

Slightly tangential to your original trade, but I always wondered how to play earnings season by selling iron condors and holding them past earnings, 

 

This is entirely opposite to Kim's way of trading straddles and calendars and selling before earnings, 

 

However, I'm wondering if you can sell iron condors, split out your trades like to avoid individual company risks, if you make good enough educated guesses with good position sizing, if you can eek out a profit with the winners and as few catastrophic losers as possible if you trade this with significant number of occurrences. 

 

e.g., TastyTrade's Iron Condor trading way (first minute): 

 

Curious if anyone trades in this manner by selling vol and betting that the underlying won't move beyond the expected move? 

 

Best,

PC

[Edwin 63]

Hi, Paul, I had sent you a private message about this to you (butterflies, debit/credit spreads, tight iron condors, etc. might provide best risk vs. reward and reasonable probability of profit), and also commented on the GMCR trade on another thread about this topic.  I've seen multiple times in the past few quarters where their callers, and even they themselves (Tom Sosnoff, Liz&Jenny, etc.) admit that their biggest losers are earnings plays where they sell strangles (e.g. LNKD in the previous quarter, WYNN, NFLX, AMZN, GMCR & DIS this week, etc.).  They are constantly repairing earnings losers by rolling out in time.  The challenge of this trading style is managing theoretical unlimited risk on some of these trades, and then having to deal with unexpected moves that are 2-3x+ standard deviations.  Some alternative suggestions (outside of SO) would be to stick with ETFs to sell premium in, rather than volatile earnings results.  If you want to trade stock around earnings events, you could also look at buying shares on oversold earnings results, or selling puts in something you want to own.