In my previous article, I described a strategy of buying strangles a few days before earnings and selling them just before earnings. In this article, I will show why it might be not a good idea to keep those strangles through earnings.
As a reminder, a strangle involves buying calls and puts on the same stock with different strikes. Buying calls and puts with the same strike is called a straddle. Strangles usually provide better leverage in case the stock moves significantly.
So let’s see how it works. First, you must identify stocks which have a history of big post-earnings moves. Some examples include Netflix (NASDAQ:NFLX), Google (NASDAQ:GOOG), F5 Networks (NASDAQ:FFIV), Priceline (NASDAQ:PCLN), Green Mountain Coffee Roasters (NASDAQ:GMCR), Akamai Technologies (NASDAQ:AKAM), Intuitive Surgical (NASDAQ:ISRG), Research in Motion (RIMM). Then you buy a strangle or a straddle a day or two before the earnings are announced. If the stock has a big move, you sell for a big profit.
The problem is you are not the only one knowing that earnings are coming. Everyone knows that those stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper.
Let’s examine a few test cases from the latest earnings cycle.
- Akamai Technologies (AKAM) announced earnings on Oct. 26. The $24 straddle could be purchased for $4.08. IV was 84%. The next day the stock jumped 15%, yet the straddle was worth only $3.81. The reason? IV collapsed to 47%. The market “expected” the stock to move 17-18%, based on previous moves, but the stock moved “only” 15% and the straddle lost 7%.
- Baidu (NASDAQ:BIDU) announced earnings on Oct. 26. The stock moved 4.5% following the earnings. You could purchase the straddle at $19.55 the day before earnings. The same straddle was worth $13.47 the next day. That’s a loss of 31%.
- TIVO (NASDAQ:TIVO) moved 2%, the straddle lost 29%.
- First Solar (NASDAQ:FSLR) moved 3%, the straddle lost 55%.
Now let’s check a couple of good trades.
- Netflix (NFLX) announced earnings on October 24. The stock collapsed 34.9% the next day, a move of historical proportions. The 120 strangle could be purchased the day before earnings at $24.52 and sold the next day at $43.00. That’s a 75% gain, but this is as good as it gets. This is a move of historic proportions but the trade is even not a double.
- Amazon (NASDAQ:AMZN) straddle gained 57%.
- CME group (NASDAQ:CME) straddle gained 62%.
- Mountain Coffee Roasters (GMCR) straddle gained 84%.
It is easy to get excited after a few trades like NFLX, GMCR, CME and AMZN. However, we have to remember that those stocks experienced much larger moves than their average move in the last few cycles. In some cases, the move was double what was expected. NFLX and GMCR moved more than 35%, the largest moves in at least 10 years. Chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit.
Some people might argue that if the trade is not profitable the same day, you can continue holding or selling only the winning side till the stock moves in the right direction. It can work under certain conditions. For example, if you followed the specific stock in the last few cycles and noticed some patterns, such as the stock continuously moving in the same direction for a few days after beating the estimates. Another example is holding the calls when the general market is in uptrend (or downtrend for the puts). However, it has nothing to do with the original strategy. From the minute you decide to hold that trade, you are no longer using the original strategy. If the stock didn’t move enough to generate a profit, you must be ready to make a judgement call by selling one side and taking a directional bet. This might work for some people, but the pure performance of the strategy can be measured only by looking at a one day change of the strangle or the straddle (buying a day before earnings, selling the next day).
The bottom line:
Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.
Jeff Augen, a successful options trader and author of six books, agrees:
“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.”
It doesn’t necessarily mean that the strategy cannot work and produce great results. However, in most cases, you should be prepared to hold beyond the earnings day, in which case the performance will be impacted by many other factors, such as your trading skills, general market conditions etc.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.