In my previous article, I discussed going long a straddle prior to an earnings announcement and capturing profit-- either by a move in the stock or by an increase in Implied Volatility (IV). I used Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL), and Priceline (PCLN) to illustrate the backtest for the last two years of this strategy. In this article I will expand that backtesting to include Netflix (NASDAQ:NFLX), Amazon (NASDAQ:AMZN), First Solar (NASDAQ:FSLR), Wynn Resorts (NASDAQ:WYNN), and Baidu (BIDU).
Creating a straddle consists of buying the ATM call and the ATM put simultaneously. The Greeks for this trade are as follows:
- Delta: Neutral (the trader doesn't care which direction the stock moves)
- Theta: High (the trader is buying two 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 the trader makes his money)
The tables below show the backtesting data gathered from Thinkorswim's OnDemand tab in their trading platform. The straddles were bought (seven) 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 had at least 30 days until expiration.
Click to enlarge
Here are some less glamorous results. There are some decent profits, but some losers as well. This brings into question exactly how this trade works.
- Theta: Seven days is a long time to wait for a trade materialize if your theta is -34.4, and that can hurt any option strategy. So what about purchasing the straddle five days before, or even three days before? Personally, I like to leave a little time for the stock to move, because you get far greater returns when this occurs. Therefore, I will backtest purchasing the straddle five days before the earnings announcement to view the difference in P/L.
- Delta: As the stock moves one way or another, it can generate massive profit. This is the primary goal of people trading the straddle. If somebody were to find a wedge pattern, and they are not sure which direction to play, they might choose this strategy. In terms of this earnings strategy, Delta is viewed as more of a bonus since we are concentrating on Vega.
- Vega: This is the bread and butter of this type of trade. If there is a move, that's great, but if there isn't, IV should rise into earnings and provide profit above the cost of the Theta.
These are the three Greeks that have the most impact on this strategy. Also, while looking at how these trades progressed, it begs the question -- what can be done better? Theta is a large driver of potential loss, so, what will occur by starting the trade five (5) days before the earnings announcement? Will this hurt the profit potential from a big move? Also, since Vega doesn't seem to drop dramatically the following morning, what happens if you close the trade at the market open? These are the questions I hope to answer in my next article before proceeding onto strangles and iron condors.
In summary, here is a table illustrating the results of all trades mentioned in this series.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.