This is a third article in a series of articles on trading Implied Volatility (IV) around earnings announcements.
In my first article, I described a strategy of buying a strangle few days before earnings and selling it just before the earnings are announced. The idea is to take advantage of the rising IV before the earnings. As a reminder, a strangle trade involves buying calls and puts with the same expiration.
In my second article, I described why I think it is usually not a good idea to keep those trades through the earnings. The markets tend to overprice the options before earnings to compensate for the potential risk. Post-earnings IV collapse requires the stock to make a very large move in order for those trades to make money. The move has to be much larger than expected.
If you believe that on average, options are overpriced before earnings, why not to take the other side of the trade? The idea is to reverse the long strangle trade just before earnings and to sell the strangle. However, in order to limit the risk if the stock moves much more than expected, it is wise to buy further OTM (Out of The Money) strangle, effectively converting it to an Iron Condor.
Let’s take a look at some examples.
Baidu (BIDU) was scheduled to announce earnings on October 27, 2011. The stock closed at $138.40 at the previous day. You could execute the following trade:
- Buy BIDU Nov. 2011 120 put
- Sell BIDU Nov. 2011 125 put
- Sell BIDU Nov. 2011 155 call
- Buy BIDU Nov. 2011 160 call
You would get a credit of $1.97. The margin requirement would be $303 per spread. The trade would be protected against 10-11% move in both directions. The next day the stock moved up 4.5% and the trade could be closed for 51% gain.
Google (GOOG) was scheduled to announce earnings on October 13, 2011. The stock closed at $559.00 at the previous day. You could execute the following trade:
- Buy GOOG Oct. 2011 515 put
- Sell GOOG Oct. 2011 520 put
- Sell GOOG Oct. 2011 600 call
- Buy GOOG Oct. 2011 605 call
You would get a credit of $2.65. The margin requirement would be $235 per spread. The trade would be protected against 7-8% move in both directions. The next day the stock moved up 5.8% and the trade could be closed for 45% gain.
The choice of strikes depends on your risk tolerance. You could do the trade with more distant strikes to protect against an even larger move, but this would reduce the credit and the potential gain. The idea is not to go after homeruns but to make a consistent 20-40% profit without taking a huge directional risk. The gains will come from a quick IV crash assuming the stock won’t move beyond the short strikes.
Of course there is always a risk that the stock will make a monster move and the trade will be a big loser. This was the case with Netflix (NFLX) and Coffee (GMCR). Both stocks collapsed 35-40%, the largest moves in the last 10 years for both stocks. However, those are exceptions. In most cases, even if the stock moves more than expected, the IV collapse should help to limit the loss.
What are the best candidates for those trades?
High priced stocks would work better than low priced stocks. When you see the IV in triple digits before the earnings, this might be a good sign to execute the trade. You need to believe that the realized post-earnings move will be smaller than the expected move. List of the potential candidates includes:
- Google (GOOG)
- Priceline (PCLN)
- Baidu (BIDU)
- Wynn Resorts (WYNN)
- First Solar (FSLR)
- Amazon (AMZN)
- F5 Networks (FFIV)
- Siena (SINA)
- Netflix (NFLX)
Most of those stocks moved less than expected in the current earnings cycle and the Iron Condor trades would make decent money. AMZN and NFLX were the only exceptions.
The bottom line:
If you believe that the stock is going to move less than the markets expect, it might be a good idea to place an Iron Condor trade just before the earnings when IV peaks and close the trade the next day after the IV crash. Position sizing is the key here – you should be able to make a decent profit most of the time, but you have to assume that some of the trades will suffer a significant loss.