Earnings season is on the near-term horizon, and so option traders start to consider their plays. Earnings can make for a bumpy ride but this can also mean opportunity. In this article, I'm going to explain one way of initiating a commonly-used earnings play (the iron condor) but in a really efficient way that looks to maximize the return. Learning to trade iron condors is now a core option trading skill for many investors.
The iron condor is a popular earnings play, especially for traders who have no real directional bias. Let's say you are watching Apple (NASDAQ:AAPL) over earnings but you really don't know whether the results will be bullish or bearish for the stock. That's okay; there are still plays to profit from. The iron condor is a strategy that option traders typically look to use when:
- they don't have a strong directional preference to the stock
- they want their total risk to be limited.
- they want to have exposure to implied volatility
Now a lot of option traders over earnings will look to short implied volatility because typically it will fall a great deal after the earnings are released. It makes sense for the implied volatility to fall because the uncertainty surrounding the company's results vanishes. So falling implied volatility is usually a fairly safe prediction to make.
Another feature of earnings is of course that the stock price can move quite drastically, certainly more than it does on a day-to-day basis. So this is the flip-side to being short implied volatility; there is risk that the actual volatility will be high, and this can hurt a short volatility position such as an iron condor. But, the iron condor does have the advantage over other short option premium trades, in that the risk is limited. Other short strategies, such as a short straddle or a short strangle, have almost unlimited downside potential.
A third feature of earnings, which is often overlooked by iron condor traders, is that implied volatility will often rise before it falls. In the weeks or days leading up to the earnings announcement, the implied volatility can rise, as investors become nervous as to what the results will mean for the stock's price.
So how do we use these features to create an efficient, limited-risk earnings play? Here is one method, using AAPL as an example.
1. In the week or so before earnings, we can look to buy a strangle (i.e. to buy an out-of-the-money put and an out-of-the-money call). So we are going long options; we are hoping to benefit from the expected increase in implied volatility before the earnings announcement. There is a risk that the implied volatility will not increase and also that theta will decay our options. But on the plus side, by owning options we will also be exposed to windfall profits if anything crazy happens to AAPL in the meantime.
If everything goes to plan, we will profit from the increase in implied volatility in the run-up to the results.
Choosing the strike of the put and call options to buy: This strangle is going to form the long side of our iron condor. So look to buy a put and a call with deltas that are smaller than those of the options you would usually use for a short iron condor position. With AAPL at $690, this might be something like the $610 puts and $770 calls, but it really will depend on where the stock price and implied volatility is near the time as well as your trading preference.
2. In the day or so before the announcement, we look to sell a strangle. The strikes of this strangle will be 'inside' the strikes of the strangle we are already long. In this way we are completing the iron condor; this is known by traders as 'legging' a strategy. Rather than trading the iron condor all at the same time, we are building it over time. Perhaps the strikes will be something like the $630 puts and $750 calls, leaving us with the $610/$630/$750/$770 iron condor which we are short for a net credit.
3. After the announcement, we are hoping that the implied volatility will fall considerably and that we will be able to buy back the entire iron condor for a profit or indeed continue to hold the short position until expiration.
One extra remark: If the stock moves considerably after you have initiated the long strangle position, you may want to re-balance the strikes. In other words, you may want to roll your strangle up or down so that you don't have too much directional bias (unless this is something you actively like). This rolling can be profitable in itself if your strangle has increased significantly in value, but it could involve additional cost that should be factored in.
The Bottom Line
This earnings play is efficient in that it is aiming to profit from the earnings in different ways at different times. Essentially, it looks to buy implied volatility before it goes up, and then sells it short before it falls. By buying low as well as selling high, this method looks to make extra profit compared to most options earnings plays which just look to short the volatility a day or so before.
In exchange for this potential extra reward, there can of course be extra risk. But for the smart option trader, this method is certainly worth adding to his or her earnings play repertoire.