So if options are on average overpriced before earnings, why not to sell those options and hold the trade through earnings?
There are few ways to sell options before earnings to take advantage of IV crash.
One if through an Iron Condor. Many options sites do this strategy on a regular basis, based on high IV rank alone. I described here why selling options based on high IV rank alone might be not a smart move. The article described selling iron Condor on NFLX, based on the very high IV rank of NFLX options before earnings.
Unfortunately, NFLX is one of the worst stocks to trade this strategy. While options on average tend to be overpriced before earnings, NFLX is one of the exceptions. In fact, it moves on average more after earnings than the options imply. So there is no statistical edge to sell NFLX options. The opposite is true - there might be a statistical edge to actually buy them and hold through earnings.
Another strategy to take advantage of elevated IV is through a calendar spread, where you sell the near term options and buy longer term options.
So when you buy options before earnings (via straddle or strangle) you want the stock to move. If it does, the gamma gains will outpace the IV collapse.
When you sell options before earnings (through calendar or Iron Condor), you want the stock to stay relatively close to the current price.
In the straddle article, I described a TWTR trade from one of the options "gurus" that has lost 55%. The same guru recommended the following calendar spread before TXN earnings:
Sell -25 TXN OctWk4 53 Call
Buy 25 TXN Nov15 53 Call
The rationale of the trade:
Over the years, (TXN) has been one of my favorite earnings plays to trade. A very consistent winner, I have almost exclusively used a Neutral Calendar Spread on it, which is a strategy that takes advantage of over-priced options (high Implied Volatility) and time-decay. This strategy works best with stocks that have weekly options, and (TXN) has these available.
Historically, (TXN) is just not a very volatile stock. Every rare so often, even when the stock has moved more than expected, the Neutral Calendar Spreads hold up extremely well.
Last quarter, the stock had the following price movement after reporting earnings:
Jul 23, 2015 49.84 51.26 49.59 50.51 13,271,800 50.17
Jul 22, 2015 48.30 49.64 48.00 49.30 15,381,500 48.97
This trade is priced great, so recommend getting in as soon as possible. 10/10.
Fast forward to the next day after earnings: TXN gaped up 10%, and the calendar spread has lost 90%+. So much for "the Neutral Calendar Spreads hold up extremely well."
The rational behind holding calendars through earnings is that IV of the short options will collapse much more than the IV of the long options, so the short options will lose much more than the long options and the spread will make money. While this is true, the calendar will make money from IV collapse only if the stock doesn't move much after earnings. The rule of thumb is: look at the "expected move" as measured by ATM straddle value before earnings. If the stock moves less than the expected move after earnings, the calendar will make money. If it moves more, the calendar will lose money. And if it move much more than expected, the calendar will lose a lot, because the time value of both options will be close to zero.
And here lies the problem: even if you have a long term edge (buy straddle on stocks that move more than expected and buy calendar on stocks that move less than expected), from time to time those stocks will not behave "as expected, based on historical data", and the trades will be big losers. When this happens, there is nothing you can do to control the risk and minimize the loss.
That said, it doesn't mean you cannot use one of those strategies and hold through earnings, assuming you use the right strategy for the right stocks. But you need to assume a 100% loss right front, be fully aware of the risk and use the correct position sizing. Those options "gurus" who fail to even mention the risks don't do their job properly.
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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.
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 decrease 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.
In fact, it wouldn’t surprise me if those articles weren’t algorithmically generated based on whatever AP news story is trending.
Just looking at today’s news makes the point:
Fox Business has declared that Twitter’s profits are up because Trump demanded fairer social media.
I’m quite certain that Donald Trump’s call for a fairer social media had very little to do with the bump in Twitter’s stock price. But saying “user numbers are up, and profits are up” doesn’t generate as much click bait as anything involving Donald Trump – from readers on both sides of the US political aisle. Anyone who regularly follows financial headlines knows of just how laughable a lot of the supposed claimed correlations are.
Analysts grasping at straws trying to explain market movements becomes particularly laughable when looking at the options markets. What is clear reading option market news pieces is that writers understand very little about options or the reasons option traders enter trades. For some reason, most of the media assumes all option trades are bets on prices moving over a period of time. If traders buy puts, financial writers think the stock price is going down. If traders buy calls, those same writers think the pricesare going up. It’s a very limited analysis.
In actuality, many option traders, Steady Option traders included, trade options to make money from volatility swings, to hedge existing positions, to help exit large stock positions, to help enter into long/short positions (a form of a hedged position), and a host of other reasons. It is impossible to look at a ticker and see “500 contracts of the 150 puts on stock ABC were bought” and conclude the reason for the purchase was because investors are betting on a price decline.
A recent article on TSLA indicates this exact point.
The author saw that “investors bought 5,000 weekly puts expiring April 26 with a strike price of $200…and 5,000 monthly contracts expiring in late June.” The author concluded this was a “type of crash protection” against coming earnings. This analysis is possibly correct, but more likely than not wholly incorrect. On this same day, there were also the same amount of the May monthly 200 put sold. In other words, it looks like that trader entered into:
BTO April 26 200 Put STO May 17 200 Put Which all Steady Option members should recognize as an earnings diagonal trade. Given that earnings for TSLA are approaching (April 24), to me, it seems like this is even more likely of a possible trade. Further, I would conclude this was an earnings diagonal trade because it looks like the position was closed today (due to option volumes on the same positions). Reporters don’t appear to consider this point.
Just as commonly, if there’s not a “matching” trade to see a diagonal or straddle setup, is the fact that most very large option positions are taken for hedging reasons or to assist in the liquidation of large positions. For example, if Joe Smith trader owned AAPL stock bought 5 years ago, Mr. Smith has well over one hundred percent gains. If Mr. Smith still has faith in AAPL, he may not want to sell (or incur capital gains taxes), but he also doesn’t want to keep that much risk on the table. So,he buys the June 2020 150 puts for $3.00. This means he’s locking in a 50% gain for well over a year for only 1.5% of the current price. This is not a “bet” that the stock price is going to decline. It’s locking in gains. If an institution owns 10m shares of AAPL, it probably has a duty to enter into a hedge such as this. There is no way to view a single options trade and make a prediction on “market sentiment.”
So why should we even read options news and reporting? Well I do it to see potential options trades. Higher volume trades typically mean more liquidity and tighter spreads (though not always), which means I can option trade for “cheaper.” High volume announcements also get me to look at just how that trade might have been structured, thereby giving an idea for other trades. Just because a reporter is ignorant as to the reason for a trade does not mean an options trader cannot pull out worthwhile information for their own uses – while laughing at the reporter’s lack of option knowledge and hopefully making money in the process.
Christopher Welsh is a licensed investment advisor and president of LorintineCapital, LP. He provides investment advice to clients all over the United States and around the world. Christopher has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Christopher has a J.D. from the SMU Dedman School of Law, a Bachelor of Science in Computer Science, and a Bachelor of Science in Economics. Christopher is a regular contributor to the Steady Options Anchor Strategy and Lorintine CapitalBlog.
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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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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The first question you need to answer is: will you hold your position through earnings, or will you close it before the announcement.
In some of my previous articles, I described few ways to trade earnings if you don't want to hold the trade through the announcement. Our favorite ways to do it are with Straddles and Calendar Spreads. Personally I don't like to hold those trades through earnings. But if you decide to do so, please make sure you do it the proper way and understand the risks.
So if you decided to hold, the next questions would be: directional or non directional? Buy premium or sell premium?
Here is a simple way to look at potential trades. The options market will always tell you how much stock movement the options market is pricing in for earnings, or any event.
For example, let’s take a look at what the options market was expecting from Apple (AAPL), which reported earnings last month.
With AAPL stock trading at 190 we need to look at the price of the straddle closest to 190. And these options need to be the calls and puts that expire the week of earnings.
In this case, with earnings on July 31, we look for the options that expire on Friday, August 3. The calls were worth approximately $4.85, and the puts were worth $4.27 just before earnings were announced. When we combine these two values it tells us that the options market is pricing in an expected move of $9.12, or 4.8%, after earnings. This is what we call the "implied move".
Now you need to do some homework and decide if you believe the options are overpriced (and the stock will move less than the implied move) or underpriced (and the stock will move more than the implied move).
If you believe that the options are underpriced, you should buy premium, using a long straddle or a long strangle.
If you buy a straddle, then the P/L is pretty much straightforward:
If the stock moves more than the implied move after earnings, your trade will be a winner. If the stock moves less than the implied move after earnings, your trade will be a loser. Taking AAPL earnings as an example:
The straddle implied $9.12 or 4.8% move. In reality the stock moved almost $12, or ~6.0%. Which means that the straddle return was over 25%.
Strangle is a more aggressive strategy. It would usually require the stock to move more to produce a gain. But if the stock cooperates, the gains will be higher as well. In case of AAPL, doing 185/195 strange would produce over 40% gain (all prices are at the market close before and after earnings).
Obviously if the stock did not cooperate, the strangle would lose more as well. Which makes it a higher risk higher reward trade.
If you believe that the options are overderpriced, you should sell premium. You can sell premium in one of the following ways:
Sell a (naked) straddle. This strategy is the opposite of buying a long straddle, and the results will be obviously opposite as well. If the stock moves more than expected, the trade will be a loser. If it moves less than expected, it will be a winner.
Sell a (naked) strangle. This strategy is an opposite of buying a long strangle, and similarly, a more aggressive trade. Take the last FB earnings for example. Selling 1 SD strangle would produce a $208 credit. When the stock was down almost 20% after earnings, the trade was down a whopping $2,407, which would erase 12 months of gains (even if ALL previous trades were winners). This is why I would recommend never holding naked options positions through earnings. The risk is just too high.
Buy an iron condor. This strategy would involve selling a strangle and limiting the risk by buying further OTM strangle. In case of a big move, your loss is at least limited. Selling options around 1 SD would produce modest gains most of the time, but average loss will typically be few times higher than average gain.
Buy a butterfly spread. This strategy would involve selling a straddle and limiting the risk by buying a strangle. In case of a big move, your loss is at least limited, like with iron condor. This strategy has much more favorable risk/reward than iron condor, but number of losing trades will be much higher as well.
Buy a calendar spread. This strategy would involve selling ATM put or call expiring on the week of earnings and buying ATM put or call with further expiration. The rationale is that near term short options will experience much bigger IV collapse than the long options, making the trade a winner. To me, this would probably be the best way to hold through earnings in terms of risk/reward and limiting the losses. As a rule of thumb:
If the stock moves as expected after earnings, all strategies will be around breakeven. If the stock moves more than expected after earnings, all premium buying strategies will be winners, and all premium selling strategies will be losers. So which one is better?
To me, any strategy that involves holding through earnings is just slightly better than 50/50 gamble (assuming you did your homework and believe that you have an edge). Earnings are completely unpredictable. Selling options around earnings have an edge on average for most stocks, but they have a much higher risk than buying options, especially if the options are uncovered. Those "one in a lifetime events" like Facebook 20% drop happen more often than you believe.
Many options "gurus" recommend selling premium before earnings to take advantage of Implied Volatility collapse that happens after earnings. What they "forget" to mention is the fact that if the stock makes a huge move, IV collapse will not be very helpful. The trade will be a big loser regardless.
Directional or non directional?
So far we discussed non directional earnings trades, where you select ATM options. But those trades can be structured with directional bias as well. For example:
If you were bullish before AAPL earnings and believed the stock will go higher, instead of buying the 190 straddle, you could buy the 185 straddle. This trade would be bullish, and earn more if the stock moved higher, but it would also lose more than ATM straddle if you were wrong and the stock moved down. As an alternative, you could buy an OTM calendar (for example, at $200 strike). If you were right, you would benefit twice: from the stock direction and IV collapse. But you would need to "guess" the price where you believe the stock will be trading after earnings with high level of accuracy. If you guess the direction right, but the stock makes huge move beyond the calendar strike, you can still lose money even if you were right about the direction.
For example, the 190 (ATM) calendar would lose around 40-50% (which was expected since the stock moved more than the implied move). But the 200 (OTM) calendar would gain around 120% since the stock moved pretty close to the 200 strike, so you gained from the IV collapse AND the stock movement.
Earnings trades are high risk high reward trades if held through earnings. Anything can happen after earnings, so you should always assume 100% loss and use a proper position sizing. Traders who advocate those strategies argue that they can always control risk with position sizing, which is true.
But the question is: if I can trade safer strategies and allocate 10% per trade, why trade those high risk strategies and allocate only 2% per trade? After all, what matters if the total portfolio return. If a trade which is closed before earnings earns 20% (with 10% allocation), it contributes 2% growth to the portfolio. To get the same portfolio return on a trade with 2% allocation, it has to earn 100%.
Is it worth the risk and the stress? That's for you to decide.
How We Trade Straddle Option Strategy Buying Premium Prior To Earnings - Does It Work? Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings How We Trade Calendar Spreads Long Straddle Through Earnings Backtest
Here is how their methodology works:
In theory, if you knew exactly what price a stock would be immediately before earnings, you could purchase the corresponding straddle a number of days beforehand. To test this, we looked at the past 4 earnings cycles in 5 different stocks. We recorded the closing price of each stock immediately before the earnings announcement. We then went back 14 days and purchased the straddle using the strikes recorded on the close prior to earnings. We closed those positions immediately before earnings were to be reported.
TSLA, LNKD, NFLX, AAPL, GOOG Past 4 earnings cycles 14 days prior to earnings - purchased future ATM straddle Sold positions on the close before earnings
Future ATM straddle produced average ROC of -19%.
As an example:
In the previous cycle, TSLA was trading around $219 two weeks before earnings. The stock closed around $201 a day before earnings. According to tastytrade methodology, they would buy the 200 straddle 2 weeks before earnings. They claim that this is the best case scenario for buying pre-earnings straddles.
Wait a minute.. This is a straddle, not a calendar. For a calendar, the stock has to trade as close to the strike as possible to realize the maximum gain. For a straddle, it's exactly the opposite:
When you buy a straddle, you want the stock to move away from your strike, not towards the strike. You LOSE the maximum amount of money if the stock moves to the strike.
In case of TSLA, if you wanted to trade pre-earnings straddle 2 weeks before earnings when the stock was at $219, you would purchase the 220 straddle, not 200 straddle. If you do that, you start delta neutral and have some gamma gains when the stock moves to $200. But if you start with 200 straddle, your initial setup is delta positive, while you know that the stock will move against you.
It still does not guarantee that the straddle will be profitable. You need to select the best timing (usually 5-7 days, not 14 days) and select the stocks carefully (some stocks are better candidates than others). But using tastytrade methodology would GUARANTEE that the strategy will lose money 90% of the time. It almost feels like they deliberately used those parameters to reach the conclusion they wanted.
As a side note, the five stocks they selected for the study are among the worst possible candidates for this strategy. It almost feels like they selected the worst possible parameters in terms of strike, timing and stocks, in order to reach the conclusion they wanted to reach.
At SteadyOptions, buying pre-earnings straddles is one of our key strategies. It works very well for us. Check out our performance page for full results. As you can see from our results, "Buying Premium Prior To Earnings" is still alive and kicking. Not exactly "Nail In The Coffin".
Comment: the segment has been removed from tastytrade website, which shows that they realized how absurd it was. We linked to the YouTube video which is still there.
Of course the devil is in the details. There are many moving parts to this strategy:
When to enter? Which stocks to use? How to manage the position? When to take profits?
And much more. But overall, this strategy has been working very well for us. If you want to learn more how to use it (and many other profitable strategies):
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How We Trade Straddle Option Strategy
Can We Profit From Volatility Expansion into Earnings
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
Long Straddle: A Guaranteed Win?
How We Made 23% On QIHU Straddle In 4 Hours
By Jacob Mintz
(My full options education article on why buy-writes have the exact same risk/reward as selling naked puts is at the end of this article.)
The second reason I closed the position was there was a chance that SE would report earnings during the May expiration cycle. That would potentially bring another layer of risk to our May buy-write position. As you can see in the graphic below my options trading tool is estimating earnings will be reported the Wednesday before expiration, which would certainly keep the value of the buy-write high through earnings.
Another way I can determine when a company is due to report earnings is by comparing the volatility of the options each month. The volatility/price of options in the reporting month is higher than the months before and after earnings. Here is an example using Zendesk (ZEN), which will report earnings tonight:
What you can see in this graphic is that with the options expiring May 17 option volatility is 56.17, way more expensive than the June 21 option volatility, which is 41.77. In essence, the price of options/volatility is telling you that ZEN’s earnings are in the May option expiration.
Now let’s circle back to SE. Yesterday, the May option volatility in SE was significantly more expensive than June. And because of that I assumed that SE would report earnings in May.
However, based on a trade today, and how the options market is reacting to this trade, I now believe that SE’s earnings will come during the June expiration cycle, not May. First, here is the trade:
Seller of 7,500 Sea (SE) May 25 Calls for $1 – Stock at 25
Buyer of 7,500 Sea (SE) June 25 Calls for $1.90 – Stock at 25
This trade, and the subsequent volatility shift, would lead me to believe earnings are now in June. As the graphic below shows, the May volatility is down 6.7 points and now below the June volatility. Yesterday the May volatility was approximately four points higher than June … and today June is now 2.5 points higher than May (48.8 vs. 46.19).
The earnings date for SE is still not confirmed. However, by paying attention to the price of options/volatility you can get a good read on when the options market is predicting a company will report.
Below is an options education article I wrote several years ago demonstrating that while Covered Calls/Buy-writes are considered a safe trade, and Naked Put Sales are perceived to have high risk, at the end of the day they have the EXACT same risk/reward.
Buy-Write vs. Naked Put Sale
Buy-writes, also known as covered calls, are one of the general public’s most popular options trading strategies. Selling naked puts (the sale of a put in an stock or index without a stock position), on the other hand, is feared by the general public as it’s considered to have much greater risk than a traditional buy-write. But when you break down the profit and loss potential of the two strategies, you can see that they’re identical.
Let’s start by looking at a buy-write/covered call:
A covered call is a strategy in which the trader holds a long position in a stock and writes (sells) a call option on the same stock in an attempt to generate income. Because the trader sold a call against his stock position, his upside is now limited.
For example, let’s say you own 100 shares of Alcoa (AA), which is currently trading at 13.99. You then theoretically sell one AA July 14 Call (expiring 7/19/2014) for $0.51 for each of your 100 shares.
Let’s take a look at a few scenarios for this trade:
In this scenario, AA shares trade flat for the next month and the stock stays below the 14-strike price. At this point, the options you sold will expire worthless, and you will have collected your full premium of $0.51 per share ($51). Thus you will have created a yield of 3.78% in one month’s time.
In this scenario, AA shares fall to 13.48. At this point, the options you sold will expire worthless and you will have collected your full premium of $0.51 per share ($51). However, your 100 shares of AA will have lost $51 of value. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls against your stock position.
In this scenario, AA shares fall to 13. Once again, the options you sold will expire worthless and you will have collected your full premium of $0.51 (or $51). However, your shares of AA will have lost $99 of value, leaving you down $48 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.
In this scenario, AA shares rise above 14. At this point, the owner of the 14 calls will exercise his right to buy the stock from you. This will leave you with no position. However, you have collected your $0.51 (or $51) and made $0.01 on the stock position.
Here is the profit and loss graph of this trade:
Now let’s take a look at the scenarios of selling a Naked Put in the same stock. (Remember, selling naked puts is the sale of a put in a stock or index without a stock position.) With stock AA trading at 13.99, we could sell the July 14 Puts (expiring 7/19/2014) for $0.51.
Let’s take a look at a few scenarios for this trade:
In this scenario, AA shares trade flat for the next month and the stock stays below the 14-strike price. At this point, the options you sold will expire in the money, and you will have collected your premium of $0.51 per share ($51). Now you will be long the stock, but will have created a yield of 3.78% in one month’s time. At this time, you could simply sell the next month’s calls against your stock position.
In this scenario, AA shares fall to 13.48. At this point, the puts you sold will expire in the money. Thus you will buy the stock at 14. However, since you collected your full premium of $0.51 per share ($51) this makes up for the loss on the stock. Thus, you are breakeven on the trade. At this time, you could simply sell the next month’s calls (switching to a buy-write now that you own shares) against your stock position.
In this scenario, AA shares fall to 13. At this point, your puts are in the money so you will be forced to buy the stock at 14. You will have collected your full premium of $0.51 (or $51). However, your shares of AA will have lost $99 of value, making you down $48 on the trade. At this time, you could simply sell the next month’s calls against your stock or exit the entire position by selling your stock.
In this scenario, AA shares rise above 14. At this point, the puts you sold will expire worthless and you will have collected your full premium of $0.51, or a yield of 3.78%.
Here is the profit and loss graph of this trade:
So what jumps out about these two charts? They are absolutely identical! The most you can make is the same, and the most you can lose is the same.
We can go through this exercise hundreds of times but each time the profit and loss graphs will be identical. Thus, executing a buy-write is “synthetically” identical to selling a naked put.
Jacob Mintz is a professional options trader and editor of Cabot Options Trader. He is also the founder of OptionsAce.com, an options mentoring program for novice to experienced traders. Using his proprietary options scans, Jacob creates and manages positions in equities based on risk/reward and volatility expectations. Jacob developed his proprietary risk management system during his years as an options market maker on the Chicago Board of Options Exchange and at a top tier options trading company from 1999 - 2012. You can follow Jacob on Twitter.
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