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Dave W

Hold-Through Earnings Calendar Trades and Closure Issues

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@Yowster or others,

I'm hoping to get some advice. I occasionally trade unofficial hold through earnings (HTE) calendars and have run into a recurring issue. After earnings, sometimes the price jump in the stock results in my calendar becoming deep in the money. When I try to close out the deep ITM calendar, the market makes it very difficult or impossible for me to close out at a reasonable price.

 

For example, this recently happened to me on RHT. I had an 82C calendar spread March 31 short / April 7 long and at the close before earnings on March 27 the stock price was $82.32. About an hour after the open on March 28, RHT stock was at $86.93. So my 82C were $4.93 ITM. But the mid-price to close out the spread was in a kind-of 'backwardation' (yes, I know that isn't the exact right term, but the situation seems similar). The mid for the short leg was $5.00 and the mid for the long leg was $4.90, so a debit of $0.10 to close the spread. Paying a $0.10 debit to close the spread (or even closing at $0.00) seemed unreasonable given that if I held the short leg through expiration, any premium to close the short options would be gone and hopefully the long option would recover some premium ($0.10 to $0.15 based on my review of other RHT options in different time periods).  So I held the spread through expiration and got assigned. I closed out the position the following day using a combo stock / option order on TOS.

 

I'd like someone who has done a number of these HTE trades to help me understand:

 

1. Has this ever happened to you? How would you recommend closing the trade when the price to close out the calendar spread is "way off" from what seems reasonable (e.g., having to pay a debit to close)?

 

2. If I do hold through expiration and get assigned, am I still 100% covered by the long option? In other words, will the changes in the long option prices offset changes in the short stock position exactly? I'm guessing the answer is no, but I haven't really looked at this yet and am not sure the best way to model it.

 

I appreciate the advice. Thank you!

Edited by Dave W

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@Dave W Yes, this scenario has occasionally happened to me.  Here are a few thoughts to closing out the trade at a reasonable price:

  • Realize that bid/ask spreads are typically much wider than normal on the morning after the earnings are released.  It can often take multiple hours for them to get back to close to normal widths - especially for stocks that don't have big options trading volume or OI.
  • Look at the value of the OTM calendar at the same strike (in your case look at the value of the 82 put calendar) and use that as a starting point for your limit order to close you ITM calendar.   Sometimes put and call calendars have different prices (due to dividends or other things) but when your strike is farther away from ATM then that difference doesn't matter so much.  If you don't get filled at this price, lower your limit order by small increments until you get filled.   In practice, you should never have to get filled at a debit to close a calendar, regardless of what the mid-point price is.

Regarding being covered on assignment - I believe you are totally covered.   For example, after assignment you are short 100 shares of RHT at a price of $82.  But you also have a long call that allows you to buy 100 shares (and cover your short) at $82.   So your excess value is whatever time premium is left in that long call (provided that you close both positions at the same time).  In your case, since it was only a 1-week calendar you're not going to have much time premium unless the stock price drops quite a bit.   But worst case you would be getting out at the same price, which is the same as closing the calendar spread at zero (and ignoring any margin interest you have to pay on your short stock).

 

I should note that for these HTE calendars, I typically go more than one week out with my long leg because when it's only one week difference the post earnings IV drop will hit the long leg significantly too.  By going out to the next monthly the IV drop hits the long leg much less.   This also means it takes a much bigger stock price move to have the calendar be worthless when compared to the move it takes to make a 1-week calendar worthless.

Edited by Yowster

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@Yowster,

 

Thanks for the detailed answer. Very helpful. To clarify one point, ...

Quote

In other words, will the changes in the long option prices offset changes in the short stock position exactly?

 

The point you made, and I agree, is that I am covered by the long leg so I can't incur huge losses. But implicit in what you said, and was really what I was getting at with the quote immediately above, is that any time value in the long option is 'at risk', so the changes in the total value of the long option will not "dollar for dollar" offset the changes in the short stock position. Agreed, with one week to expiration this might not be a huge deal (although $0.10 for 1 week of time could represent a significant part of the potential profit), but I also typically use a 2 - 4 week difference in time between the front and back option when I HTE (the example above was an exception). For me, this is a risk that needs to be considered when I determine whether to do an HTE calendar that I hadn't previously considered (and another risk that typically doesn't come into play in the standard SO pre-earnings calendars).

 

Again, thanks for the detailed answer. Much appreciated.

Edited by Dave W

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    • By Kim
      The reason is simple: 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.


      Kirk Du Plessis from OptionAlpha seems to agree. 

      He conducted a backtest proving that holding a straddle through earnings is on average a losing proposition.

      Here are the highlights of his research.
       
      Key Points:
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      Did a long straddle every time earnings were present, all the way back to 2007 through now. This is a lot of earnings cycles and a lot of different information for Apple. Since then Apple has had a considerable move, which really challenges the validity of the strategies. We entered a long straddle at the money the day before earnings and took it off the next day. The stock was trading at $90; we bought the 90 put and the 90 call and closed it right after earnings were announced the next morning. 
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      Entered the same long straddle position, entering right before earnings were announced and exiting again right after earnings were announced. This strategy only won 27% of the time, which is a huge miss for Facebook percentage-wise. These long options strategy simply do not perform as well as we think over time.
      Results:
      Had an annual return of 0.70%. Only a couple of months ended up being the determining factor to keep it above board.  If you missed a couple of those really big moves or if Facebook moved much higher than expected, then it would have resulted in a much more negative return. On the counter side, if you had traded the short option strategy it would have worked out well, generating a positive expected return.  On average, the market priced these straddles at about $5.62 before earnings. After they announced earnings, the straddle pricing went down to $1.78.  The key was that the crash in the volatility and the straddle pricing is really why this strategy was a big loser.  However, this was a really good winner for option sellers.   The average expected move in Facebook was $6.45 and the actual expected move on Facebook was $7.09. Facebook out-performed on average.  If you could remove the biggest outlier from 2013, then Facebook under-performs by $6.16. More recently, Facebook has begun to consistently under-perform its expected moves. Case Study 3: Chipotle
      With Chipotle we used the same strategy as with Apple and Facebook, entering into a long straddle right before earnings and exiting it right after earnings. 
      Results:
      The overall win rate was 35.48%. The average annual return was -2.59%, losing a significant amount of money in the trade.  This again consistently led option sellers to be the beneficiaries of the earnings trade in Chipotle. The average price of the straddle heading into the earnings event was 26.26%. The stock went from the low 60's, all the way up to the 600's and back down to 400 - so the straddles are naturally going to be more pricey.  On average the straddle price was 26.26 and after earnings the straddle price was 11.21, collapsing by more than half.  There are huge moves in Chipotle, but they do not overshadow what actually happened in the long term. Expected move in Chipotle was 7.01 and the actual move was 5.28 - the market vastly underperformed.  Conclusion:
      After big moves, we start to see expected moves and the stock expands and then smaller moves follow. Generally speaking, when the stock outperforms the expectation the next couple of cycles end up being fairly quiet.  If we do find ourselves in a quiet period where the stock has performed really well, we should be careful that it could surprise us shortly.  Likewise, if the stock has been really volatile and has outperformed and moved more than expected in the last couple of cycles that means we could potentially be more aggressive as it might underperform heading forward. Generally, there is also a lag time between the market catching up - earnings trades only happen four times a year.  The market participants don't get a lot of data throughout the year to make changes to expectations and trading habits.  If the stock has a huge move after earnings, more than expected, it might take a cycle or two for the options pricing to catch up and realize the new normal.  At the end of the day, realizing how much these numbers gravitate towards what they should be on average, long-term is really powerful.  You can listen to the full podcast here.

      This research confirms what we already knew:

      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.

      Thank you Kirk!

      The next question is of course: if holding a long straddle through earnings is a losing proposition, why not to take the other side and short those straddles?

      But lets leave something for the next article..

      Related articles:
      How We Trade Straddle Option Strategy Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? Long Straddle: A Guaranteed Win? Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings Straddle Option Overview  
    • By Mark Wolfinger
      I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play.
       
      Mark's response:
       
      1) To me they are the same, with the straddle being a subset of the strangle  In other words, a straddle is merely a strangle when the strikes and expiration dates are the same.
       
      I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike.  I prefer to sell OTM calls and puts – and that's not possible with a straddle.
       
      As far as unlimited risk is concerned, that's a decision for each trader.  I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post.
       
      2) A clarification.  In is not 'volatility' that incurs a large decrease after the news is released.  Instead it is the implied volatility of the options.  I'm fairly certain that is what you meant to say.
       
      3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be.
       
      4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news."  The market has made an estimate of how much the stock price is likely to move.  Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated.
       
      There is no formal prediction of move size.  There is nothing that says the stock will move 6.35 points.  What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options.  And it makes no difference if they are calls or puts.  At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured. 
       
      From the IV, the 'anticipated move' for the underlying is determined.  AsI said, it's not as is everyone agreed on how much the stock will move.
       
      I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move.  Many times the move is far less than expected.  That's the reason why selling options prior to earnings can be very profitable.  The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts.
       
      However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV crush. doesn't do a whole lot of good.  Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money.
       
      Also remember that part of the time that stock price gaps by far more than expected.  In that scenario, a higher quantity of formerly OTM options are now ITM.  Thus, large losses are not only possible, but they are more frequent that you realize.  Apparently your trades have worked out well (so far).
       
      Think about this:  If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago.  The truth is that these option buyers collect often enough to keep them coming back for more. 
       
      5) That means you must be selective in which options you sell into earnings news.  This is especially true when you elect to sell naked options.  You cannot options on every stock, hoping that any random play will work.  This is a high risk/high reward game.  It's okay to participate, but please be aware of what you are doing and the risk involved.
    • By ORATS_Matt
      For this reason, front month expirations will generally have higher IVs than back months. After earnings, the implied volatility falls more in the front months than in the back months for this reason.  
       
      There are various measurements to view this effect. Measuring the effect starts with estimating where IV will fall in each of the expirations. This can be accomplished by estimating an earnings effect in each month and varying the effect until the relationship between the IVs make a rational term structure. A rational term structure is where the expirations fit into a smooth curve drawn over time. The term structure is not necessarily a flat as many calculations use. Sometimes the term structure will solve to contango, with aa lower front month, or in backwardation with higher front IVs than back month IVs. 
       
      When the part of IV that is the earnings effect is extracted from the raw IV, an ex-earnings IV can be compared. Below is a list of stocks with IV 30 day divided by ex-earnings IV 30 day sorted from highest to lowest.
       
      UPS is the highest ratio at 1.31 with the IV=49.48% and ex earnings IV=37.78%.



       
      Here's a view of the monthly unadjusted ATM IV for UPS. May 27th is about 30 days out and the IV is 48%. Constructing a rational term structure taking out an earnings effect over the months makes a 38% ex earnings IV for May 27th. The front month of 4/29/22 trading at 106% IV is expected to come down to 47%. The term structure, post earnings is still in backwardwardation. 



       
      An options trade to take advantage of this high IV vs ex earnings IV is a time spread or calendar spread. 



       
      The May-20 June-17 $185 Long Call Calendar has the following profile:



       
      The break even points are estimated at $168.38 -9% and $205 +11%.
      The history of UPS moves versus expectations are below:



       
      There are two moves of +14% in the last 12 observations but the rest of the earnings moves would probably result in a winning trade.

      About the Author: Matt Amberson, Principal and Founder of Option Research & Technology Services. ORATS was born out of a need by traders to get access to more accurate and realistic option research. Matt started ORATS to support his options market making firm where he would hire statistically minded individuals, put them on the floor, and develop research to aid in trading options. He is heavily involved with product design and quantitative research. ORATS offers data and backtesting on a subscription basis at www.orats.com. Matt has a Master’s degree from Kellogg School of Business.
       
      Related articles:
      How We Trade Calendar Spreads Understanding Implied Volatility Few Facts About Implied Volatility What is Volatility Skew
    • By Kim
      First of all, as a general comment, there is no such thing as guaranteed returns in the stock market. If there was, everyone who is trading the stock market would be a millionaire.
       
      The proposed trade is called a long straddle option. 
       
      A long straddle option strategy is vega positive, gamma positive and theta negative trade. That means that all other factors equal, the option straddle will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration. For the straddle to make money, one of the two things (or both) has to happen: 

      1. The stock has to move (no matter which direction).
      2. The IV (Implied Volatility) has to increase.  
       
      In simple terms, Implied Volatility is the amount of stock price fluctuations. Being on the right side of implied volatility changes can enhance the chances of success. 
       
      The problem with the proposed setup is that you are not the only one who knows about the event - it’s a public knowledge, so market participants bid the options prices in anticipation of the event, driving IV to higher than usual levels. After the event the IV usually collapses. If the stock moves more than “implied” by the straddle price, then the straddle will be a winner. BUT more often than not, the options prices overprice the potential move, and when the stock moves less than expected, collapsed IV will make the straddle a loser.
       
      Example:
       
      NFLX was scheduled to report earnings on October 15, 2015. The stock was trading around $110, and 110 straddle around 15.50. This price "implied" $15.50 move. The following image presents the P/L chart of the trade:
       

      As we can see, the IV is around 240% for those options, reflecting the upcoming event.
       
      Fast forward 24 hours: the stock moved $9 which is a substantial move, but less than "implied" by the options prices. This is the P/L chart:
       

       
      As we can see, IV collapsed to ~85%, and the trade has lost 42%.
       
      At SteadyOptions, we trade straddles in a different way. We usually buy a straddle around 7-10 days before the event and sell it 1-2 days before the event when IV peaks. This setup can benefit from the stock moving and/or IV increase.
       
      Related articles:
      How We Trade Straddle Option Strategy
      Buying Premium Prior to Earnings
      Can We Profit From Volatility Expansion into Earnings
      Understanding Implied Volatility
      How We Made 23% On $QIHU Straddle In 4 Hours
       
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