There has been significant conversation on Seeking Alpha about straddles, strangles, and iron condors being used for pre-earnings announcements.
As most people know there can be a significant move in a stock's price following the earnings release. The best option strategies to trade a potential move are a straddle, strangle, and reverse iron condor (RIC). However, a major problem is that Implied Volatility (IV) rises into earnings and then drops significantly afterwards. We can counteract this problem by exiting the trade right before earnings and making money on the rise in IV.
Creating a long straddle consists of simultaneously:
Buying the ATM call
Buying the ATM put
Creating a long strangle consists of simultaneously:
Buying an OTM call
Buying an OTM put
For the backtesting I choose strikes with deltas below 30.
Creating a RIC consists of simultaneously:
Buying an OTM call
Selling a further OTM call
Buying the OTM put
Selling a further OTM put
For backtesting on the options being bought I choose strikes with deltas below 30.
The greeks for these trades are as follows:
- Delta: Neutral (you don't care which direction the stock moves)
- Theta: High (you are buying options which means there is a lot of theta so this position should be held no more than a week)
- Gamma: Usually low but increases as stock moves
- Vega: High (this is where you make your money)
The table below shows the backtesting data gathered from Thinkorswim's OnDemand tab in their trading platform. Apple (AAPL) was chosen to start with because it can be considered one of the "big boys" of earnings movement and IV increase. The trades were bought 7 days before the earnings announcement at approximately 9:40 AM and sold the day of the earnings announcement at approximately 3:30 PM. All options were in the front month.
From the results above you can see that there will be gains and losses but overall for Apple this seems to be a good system. The largest loss is 25% and that is in the strangle trade. However, I think you can see that this is fairly consistent. The RIC is a less risky trade since the cost of the trade is less, but your return is larger with the strangle. As always with trading, it depends on the trader, their risk tolerance, and the trade as to which strategy to use.
The biggest risk in this type of trade is that the underlying doesn't move at all and the rise in IV is not enough to counteract the loss from theta. This is why the losses are usually kept small.
Many people wonder why they shouldn't keep these trades through earnings. The answer is because you have to purchase the options well before IV starts to rise, like maybe 7 days. Your hope is that the IV 7 days before the earnings announcement equals or is higher than after the announcement. However, you loose a lot of time decay while holding those options and this means you will require a huge move to make a profit.
The reason you can't buy these positions the day before the earnings announcement is IV gets crushed afterwards because the anticipation is gone. In a following article I will show the results of shorting a straddle, strangle, and an Iron Condor trade the afternoon before the earnings announcement and selling it the morning after, assuming an afternoon announcement. This will hopefully show you why going against the volatility crush is a bad idea.