Seeking Alpha

In one of my previous articles I showed why buying a straddle the day before the Amazon (AMZN) earnings report and selling it the next day might not be a good idea. If you did it in the last eight earnings cycles, you would lose on average 17.99%. The reason is simple. Jeff Augen, a successful options trader and author of six books, explains:

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.

The last cycle confirmed the trend. Buying the 195 straddle before the announcement would cost you \$19.45. The same straddle was worth \$15.64 the day after the announcement, a 19.5% loss.

My regular readers already know that my favorite way to play earnings is buying a strangle a few days before earnings and selling it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising IV (Implied Volatility) of the options before the earnings. I described the general concept here.

In some cases I would buy an Out-of-The-Money (OTM) strangle and sell a further OTM strangle, creating a Reverse Iron Condor. This is what I did with Amazon.

On January 27, 2012, Amazon was trading around \$195. I placed the following trade:

• Sell AMZN February 2012 Week 1 180.0 put
• Buy AMZN February 2012 Week 1 185.0 put
• Buy AMZN February 2012 Week 1 200.0 call
• Sell AMZN February 2012 Week 1 205.0 call

The trade was executed at \$2.90.

On January 31, 2012, just before the earnings report came out, the stock was trading at \$194.50. The trade was sold at \$3.50, for 20.6% gain in two trading days.

So how was it possible to earn a 20% gain in two trading days on a stock that virtually didn't move?

The answer is: the Implied Volatility (IV). Let's do a post-mortem of the trade. The next part is a bit technical so please bear with me.

Let's assume that I purchased 10 contracts for a total cost of \$2,900. The initial theta for the whole trade was -\$98 per day. However, the theta accelerated as we got closer to expiration, and after four calendar days the theta was -\$205 per day. For simplicity, let's assume that the average theta was around -\$150 per day.

For those less familiar with options, the theta measures the rate at which options lose their value, as the expiration date draws nearer. Generally expressed as a negative number, the theta of an option reflects the amount by which the option's value will decrease every day. So in our case, all other factors equal, the position would lose \$150 per day or \$600 in four days. That's 20% loss on a \$2,900 position.

However, all other factors are not equal. The whole idea of the trade is that IV should rise and at least offset the theta. By how much? Here vega comes in play. The option's vega is a measure of the impact of changes in the underlying volatility on the option price. Specifically, the vega of an option expresses the change in the price of the option for every 1% change in underlying volatility (1% change means change from 60% to 61%). I call those trades "theta against vega" fight.

This trade started with average IV of 67% and ended with average IV of 120%. The vega of the whole position was +25. With IV change of 53%, the total dollar change was about +\$1,325.

So the trade gained \$1,325 due to positive vega and lost \$600 due to negative theta. Total net theoretical gain: \$725. The actual gain on 10 contracts: \$600. The difference can be attributed to slippage and some inaccuracies in my math, but you get the point.

In this case, even if IV rose to 100% only, the trade would still be profitable.

Please note that it will not always happen. Sometimes you might enter the trade when the IV is already too high and will not rise enough. In some cases, the theta will just be stronger and the trade will lose money. But the beauty of those trades is their very low risk. With RIC, it's extremely unlikely to lose more than 7-10% (if sold before the earnings report).

Let's see few examples of my recent trades.

I describe a possible Google (GOOG) trade here. The trade was closed for 14% gain and rolled to different strikes. The second trade was closed for 3% gain.

In one of the previous cycles Google strangle produced a 178% gain as a result of a strong stock movement and IV increase. This was my largest gain using this strategy. It will probably never happen again, but it illustrates the potential.

Apple (GM:APPL) didn't perform as well this cycle. The trade was just breakeven. But in previous cycles, strangles produced 102%, 45% and 31% gains. Of course strangles are more risky than RIC due to higher negative theta, but they also have higher profit potential.

Google, Amazon and Apple are among the best candidates for this strategy. Other excellent candidates are Netflix (NFLX), F5 Networks (FFIV), Priceline (PCLN), First Solar (FSLR), Green Mountain Coffee Roasters (GMCR), Akamai Technologies (AKAM), Intuitive Surgical (ISRG), Saleforce (CRM), Wynn Resorts (WYNN) and Baidu (BIDU).

You can check here for how to play Baidu earnings next week.

I hope you can see the potential of this strategy. I won't guarantee that it will double your account in one month. But if consistent and steady gains with very low risk fit your style, then this strategy is for you.