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In my first Seeking Alpha article, I described a strategy of 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 followed up with a series of articles recommending specific trades. You can read some of them here and here. This strategy is based on aiming for consistent and steady 10-15% gains with holding period of 2-5 days. Check out, for example, how it made 20% in two trading days on Amazon (NASDAQ:AMZN) while the stock was unchanged. Other examples include 14% gains in Google (NASDAQ:GOOG) trade and Baidu (NASDAQ:BIDU) trade. Those are not Home Runs, but most of those trades had very low risk, hence you could allocate 10-15% of your account to each trade. Make 10 such trades each month with average return of 10% per trade, and your account is up 10% per month.

When trading high-priced stocks and/or the time to expiration is less than two weeks, I might sell further OTM strangle, creating a Reverse Iron Condor

In this article, I would like to explain the "underneath" of this strategy.

Let's take a step back. When someone starts trading options, the first and most simple strategy is just buying calls (if you are bullish) or puts (if you are bearish). However, when doing that, you must be right three times: on the direction of the move, the size of the move and the timing. Be wrong just in one of them - and you lose money. You will also find out very quickly that options are a wasting asset. They lose value every day. If the stock doesn't move, the option is losing value. If it moves but not fast enough, it is losing value as well. It is called a negative theta. You can read more about the options Greeks here.

Another factor having a great impact on options value is IV (Implied Volatility). Rising IV will increase the option value, falling IV will decrease it. For volatile stocks, IV usually becomes extremely inflated as the earnings approach and collapses just after the announcement. This is why if you buy calls or puts before earnings and hold them through the announcement, you might still lose money even if the stock moves in the right direction.

Having said that, I would like to achieve the following three goals when trading options:

  1. Not to bet on the direction of the stock.
  2. To minimize the effect of the time decay.
  3. To take advantage of the rising IV.

The strategy of buying a strangle (or a straddle) fits all three parameters. First of all, since I'm buying both calls and puts, I'm not betting on the direction of the stock. Second, I'm holding for a very short period of time, so the impact of the time decay is minimal. Third, since I'm buying a few days before earnings, the IV in most cases will rise into earnings. However, I will be selling just before the announcement, so the options will not suffer from the IV collapse.

Now, few scenarios are possible.

  1. The IV increase is not enough to offset the negative theta and the stock doesn't move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days.
  2. The IV increase offsets the negative theta and the stock doesn't move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains. For example, Apple (NASDAQ:AAPL) strangle could be purchased on Friday before October 2011 earnings and sold the following Monday for 32% gain.
  3. The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring few very significant winners. For example, when Google moved 7% in the first few day of July 2011, a strangle produced a 178% gain. In the same cycle, Apple's 3% move was enough to produce a 102% gain. In August 2011 when VIX jumped from 20 to 45 in a few days, I had the Disney (NYSE:DIS) strangle and few other trades doubled in a matter of two days.

This is why I call those trades "renting a strangle/straddle for free" (or almost free). Even under the most unfavorable conditions, your loss is usually limited to 7-10%. But if you get a decent IV increase and/or a stock movement, the gains could be much higher.

Another big advantage of this strategy is the fact that it is not exposed to the gaps in the stock prices - in fact, it benefits from them. So you cannot suddenly find yourself down 30-50%. You can always control the losses and limit them.

Take good care of your losers - and the winners will take care of themselves.

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 have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.