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Tim spent 10 years in the private wealth management business with several firms including Merrill Lynch, Bank of America and Wachovia Securities. Tim had assets totaling over $50 million under management at the time of his retirement. He continues to advise several private accounts as well as... More
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  • Tesla Offers A Unique Earnings Play Opportunity

    Many people are familiar with using credit spreads and iron condors to generate income. During earnings season, however, corporate earnings announcements present traders with a very high probability, albeit speculative trade opportunity using these instruments.

    For the purposes of this article, I will be focusing on the iron condor. This multi-legged option instrument is created by combining a bull put spread with a bear call spread. This is done by selling an out of the money (OTM) put and buying a put further out of the money. On the call side, a trader sells an OTM call and buys a call farther out of the money. Typically income oriented investors, as well institutional investors, who favor trades with defined risk and a high probability of success, employ these trades, but they can also be used to play earnings announcements.

    Typically, as the date of a company's earnings announcement approaches, the implied volatility in the stock rises, and usually peaks the day before or the day of the announcement. When volatility increases the premiums that options traders are willing to pay rises. If there's a high level of uncertainty, the premiums can skyrocket. This is excellent for sellers of options. When you sell an iron condor, you are selling volatility; so the higher the volatility, the better. After earnings are announced much of the uncertainty will be priced into the stock and therefore there will be a precipitous drop in volatility. As a result, the price of the options that the iron condor seller sold will be much lower. With iron condors, you want to sell high and buy back at a lower price to close the position and bank your profits.

    The Trade

    On Thursday, November 5th Tesla (TSLA) will announce earnings after the market closes. Using a little simple math, we can see that options traders are betting on about a 27% move up or down from TSLA between now and the December expiry. Looking at the options chains for the December expiry, we can use a short put strike of 110 and a short call of 225. The probability of TSLA expiring below 110 is about 5% and the probability of it expiring above 225 is about 9%. I plan to sell the following iron condor:

    Sell to open 10 Dec 110 puts

    Buy to open 10 Dec 100 puts

    Sell to open 10 Dec 225 calls

    Buy to open 10 Dec 235 calls

    As of Friday's close, this order should fill for about a .90 credit. This equates to a 10% return on risk.

    I have no plans to hold this until the December expiration due to the gamma and vega risk, and will look to buy back the position for .40, which equates to about a 5% return.

    Depending on the rate of compression of volatility, I anticipate closing this position within 3-14 days of the earnings announcement.


    As I mentioned at the beginning of this article, this is a speculative trade. A few things can go wrong, and you should understand these risks no matter how low the probability of their occurrence. If TSLA were to surprise significantly to the upside or downside, there's a chance that the short strikes of this condor could be threatened. If the stock price were to penetrate 110 or 225, there's a chance that you could be assigned the shares that were shorted with the put or call. That's why I have chosen an expiry with 47 days left. The November options have an implied volatility that's 47% higher than the December, but in order to get a decent premium, we would have to place the short strikes of each wing of the condor dangerously close to the current price. In addition, with only twelve days left before expiration, there would be no time to adjust the trade using the same month. This scenario would almost insure a loss. If the worst case scenario occurred with the December expiry, adjustment by rolling up or down would be possible. This in no way insures against loss, but it does mitigate the risk.

    Looking at TSLA's historical stock movement post-earnings, the largest pop has been a 24% increase to the upside. The proposed trade places the short put roughly 32% from the current price and 38% from the short call. In addition, the market is predicting only a 27% move.

    While the probability of success is very high, the risk/reward relationship of this trade is terrible. Despite this fact, this is a very calculated, disciplined and "conservative" way to speculate on an earnings announcement. Of course there are no guarantees, but the options market is telling me that there's about a 90% chance that this trade will be successful. If there's a violent reaction to the announcement, but the price does not threaten our short strikes, we simply hold and monitor the position and allow time decay (theta) to work in our favor. This last scenario would extend the duration of this trade.

    For those who want to use this strategy, but cannot tolerate the risk of the earnings announcement, you can simply wait until the stock begins to trade after the announcement. There will be some volatility crush that will be missed, and this approach will extend the duration of the trade and decrease the rate of return, but it is a more conservative approach.

    This article was written for information purposes only and is in no way a recommendation to buy or sell any security. Readers should do their own research and/or consult a qualified financial consultant.

    Disclosure: I have no positions in any of the securities mentioned but may initiate a trade within the next 24 hours.

    Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TSLA over the next 72 hours.

    Nov 03 7:11 PM | Link | Comment!
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