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"Take calculated risks. That is quite different from being rash." - George S. Patton

In my Google (NASDAQ:GOOG) earnings trade article I described a way to play Google earnings without taking a directional risk. As a reminder, I suggested a trade called a Reverse Iron Condor. This is basically buying an Out-of-The-Money (OTM) strangle and selling a further OTM strangle. In a follow-up article I described why I think it is not a good idea holding this trade through earnings.

In this article I would like to go into more detailed discussion about choice of strikes for those trades.

As we all know, risk and reward are directly related in trading. You must take more risk to get a larger return on the trade. There is a third parameter, which is related to a potential return: probability of success. A higher probability of success translates to lower potential return and vice versa.

Let's examine three possible choices for the Google trade. All numbers are based on January 6, 2012, closing prices. The stock closed exactly at $650 that day, making the calculations easier.

Trade #1

  • Sell GOOG January 2012 635 puts
  • Buy GOOG January 2012 645 puts
  • Buy GOOG January 2012 655 calls
  • Sell GOOG January 2012 665 calls

Total debit: $8.15

Maximum gain: 23%

Stock move required for maximum gain: 2.3%

Probability of success: ~80%

The P/L graph looks like this:

(Click charts to expand)

Trade #2

  • Sell GOOG January 2012 615 puts
  • Buy GOOG January 2012 625 puts
  • Buy GOOG January 2012 675 calls
  • Sell GOOG January 2012 685 calls

Total debit: $5.25

Maximum gain: 90%

Stock move required for maximum gain: 5.4%

Probability of success: ~50%

The P/L graph looks like this:

Trade #3

  • Sell GOOG January 2012 585 puts
  • Buy GOOG January 2012 595 puts
  • Buy GOOG January 2012 705 calls
  • Sell GOOG January 2012 715 calls

Total debit: $2.10

Maximum gain: 376%

Stock move required for maximum gain: 10.0%

Probability of success: ~20%

The P/L graph looks like this:

All gains and probabilities are based on holding until expiration, which is one day after the earnings announcement. The maximum gain or loss for the Reverse Iron Condor trade is always realized only if held through expiration.

So if you are going to make one of those trades, you can choose the strikes based on your belief what the stock will do after the earnings. In trade number 1, you are risking $8 to make $2, but the stock has to move only 2.3% to achieve the maximum gain. In trade number 2, you are risking $5 to make $5, and the stock has to move 5.4% to achieve the maximum gain. In trade number 3, you are risking $2 to make $8, but the stock has to move 10.0% to achieve the maximum gain. As I mentioned, probability of success is directly related to the potential gain.

Those scenarios are based on holding the trade through earnings. If you are going to sell before the earnings, the numbers will be different, but the principle remains the same. Going further Out Of The Money requires less capital but larger pre-earnings move is required to make a profit. Closer strikes will require more capital but also have less negative theta. So no matter if you hold through earnings or sell before, closer strikes (trade 1) will give you less risk and higher probability of success but also lower potential return.

I usually choose trade 2 which gives me 1:1 risk/reward (risking $1 to make $1) and also requires only a moderate move to make money. I think it offers a good compromise between risk and reward. Of course if I sell before earnings, I will never realize the maximum gain, but the risk is also much lower. Usually I aim for 25%-40% gain in those trades.

I will be using the Reverse Iron Condor strategy to trade the upcoming earnings for other high-priced stocks like Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Intuitive Surgical (NASDAQ:ISRG), Wynn Resorts (NASDAQ:WYNN), Baidu (NASDAQ:BIDU), Priceline (NASDAQ:PCLN) and others. The same considerations will apply for those trades. It's ultimately up to a trader to structure the trade according to his/her outlook and risk tolerance.

"If you have an approach that makes money, then money management can make the difference between success and failure…I try to be conservative in my risk management. Risk control is essential." - Monroe Trout

Disclosure: I own the GOOG Reverse Iron Condor

Source: Google Earnings Trade: Risk Vs. Reward