" I hate quotations. Tell me what you know"
Ralph Waldo Emerson
It is a fact that the market makers have to keep IV at high levels going into earnings no matter if options expiration is just around the corner , simply because they don't want to get caught out on big move , therefore when the announcement is made IV collapses
This is the logic behind the strategy
Actually there are 2 strategies
The edge is by betting that the move will be less than the IV predicts, hence shorting Vega and the skew are the foundation of the play
Important to note that the inbuilt edge is that the market makers in order to protect themselves they overprice options , otherwise they would be losing a lot every time as earnings season is on
In other words they have to sell high priced straddles and strangles
Therefore the odds benefit of those selling volatility
What about a huge move ?
Could you expect to lose much ?
Maybe, but also we can work out by putting the odds in our favor
One is a Broken Wing Butterfly , which is like a regular butterfly except for having one of the spreads larger in size
A normal butterfly is basically 2 spreads ( Long and Short) ,both same size
GOOG earnings will be released on Jan. 19 after the market closes
In the next example I will use today's quotes ,bearing in mind that if the strategy is to be used , Jan. 19 quotes should be used
As of this writing GOOG @ 625.26
A normal ATM Call butterfly would be 625 / 630 / 635
and a BWB would be 625 / 630 / 640 as you can see the short spread is
Let's do some cost analysis
LONG Jan 625 Call @ 17.95 1 C
SHORT Jan 630 Call @ 15.55 2 C
LONG Jan 640 Call @ 11.20 1 C
NET 1.95 Credit
Upside B. Even = 636.95
Upside Max.Loss = 3.05
Max. Profit = 6.95
The other strategy is an Unbalanced Butterfly which basically is a hedged ratio write having more credit spreads than debit spreads
I will use 625 , 630, and 635 strikes
1 LONG 625 / 630 Spread
2 SHORT 630 / 635 Spreads
or 1:3:2 ratio
LONG Jan 625 Calls @ 17.95 1 C
SHORT Jan 630 Calls @ 15.55 3 C
LONG Jan 635 Calls @ 13.3 2 C
NET 2.10 Credit
Upside B. Even = 633.55
Upside Max. Loss = 2.90
Max. Profit = 7.10
Important to mention that both trades are done for a credit
Because as we expect the stock to move after earnings are released , we are betting only on one side so it is important to place them for a credit or at least for even money in that way if the stock moves the other way (against ) we still be making a profit by collecting the initial credit !
The other important things to do in the analysis is to ensure the breakeven to be outside of the 1 std. deviation expected move at expiration
This will make the trade higher in probability of success
Also I would recommend not to trade if the Risk Reward ratio is higher than 1
Next time I will discuss Standard deviation
Good luck !
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.