In the coming days as we get closer to the heart of earnings season I am going to introduce a couple new strategies. These will be a great way to get short volatility into an earnings announcement with limited risk.
These new strategies are:
Selling Call Spreads
Selling Put Spreads
Iron Condors
As I’ve written about in the past, volatility typically becomes very elevated in the days before a company’s earnings announcement. This is because there is great uncertainty. Think in terms of a hurricane coming toward your house. In such a situation, you would want to buy as much insurance as possible. However, once the hurricane misses your house, you would want to get rid of that insurance.
It’s the same in options. Earnings (hurricane) are coming, so everyone wants to buy volatility/insurance sending the price of options up. However once earnings are out (hurricane has passed), volatility declines dramatically as no one wants the insurance anymore.
Last earnings season, I wrote an options education piece on AAPL earnings. This is what I wrote on April 24, 2013:
Apple (AAPL) is due to report earnings this evening after the close. The stock has been in a steep decline over the last several months. It traded as high as 700 in late 2012, and is today trading at 405.
Let’s take a look at what the options market is pricing in for AAPL’s expected move after earnings are released.
Volatility is sky high! Based on the pricing of the weekly options, those that expire this Friday, the options market believes AAPL will move 30 points tomorrow. This seems like fair pricing to me. I don’t necessarily want to be short a lot of options, and I certainly don’t want to be long options because of the inevitable volatility destruction tomorrow. Think of the hurricane passing.
I am going to pick some random strikes for us to follow to see how they perform if we bought or sold them.
Apple (AAPL) reported earnings last night after the market close. The consensus reaction is mild disappointment.
Right after the numbers were released, the stock shot up nearly 30 points before slowly drifting down during the company’s conference call.
This morning, there were reductions of price targets for the stock, and the stock opened down approximately 12 points. Right now, the stock is virtually unchanged from yesterday’s closing price.
So let’s see how the options we picked yesterday performed.
Volatility for various expiration months:
April 25 volatility was 100 – now 41, which is down 59 points on the day
May 18 volatility was 44 – now 31, which is down 13 points on the day
June 22 volatility was 35– now 28, which is down 7 points on the day
Strikes that we followed:
April 26 expiration:
410 Calls were $12.50 – now $3.00, a loss of $9.50
400 Puts were $12.50 – now $3.00, a loss of $9.50
445 Calls were $2.10 – now $0.10, a loss of $2.00
375 Puts were $3.80 – now $0.20, a loss of $3.60
May 18 expiration:
410 Calls were $15.50 – now $9.00, a loss of $6.50
400 Puts were $17.00 – now $11.00, a loss of $6.00
470 Calls were $2.00 – now $0.50, a loss of $1.50
340 Puts were $1.50 – now $0.50, a loss of $1.00
June 22 expiration:
410 Calls were $19.50 – now $14.50, a loss of $5.00
400 Puts were $21.50 – now $17.00, a loss of $4.50
500 Calls were $1.70 – now $1.00, a loss of $0.70
300 Puts were $0.75 – now $0.50, a loss of $0.25
In conclusion, the stock had its 30-point move that the options market was implying, though the whole move occurred before the market opened.
Also, EVERY option we were watching was a MASSIVE loser. Volatility in these options was destroyed after the earnings release—this is what makes buying straight calls and puts for earnings in an elevated volatility environment a difficult endeavor.
To combat this volatility destruction, I often use spreads, which is a great way to minimize volatility and premium risk.
So how can we sell this elevated volatility without taking on significant risk? Selling call spreads is one strategy.
This strategy involves the selling of a call at a lower strike price while simultaneously buying a call at a higher strike price. The maximum profit on this strategy is the premium you collect. The maximum loss is the difference between the strikes minus the premium you collect.
Let’s say stock XYZ is trading at 90. You will theoretically sell the 100/105 bear call spread for $1. To execute this trade you would:
Sell the 100 calls
Buy the 105 calls
For a total credit of $1.
Here is the graph of this trade at expiration.
As you can see, as long as the stock stays below $100 by expiration, you will collect the $1 in premium. If the stock goes to 105 or above, your losses are capped at $4.
The other way you can profit is that the day after earnings are announced, volatility will be hit dramatically. Thus, that spread that you sold for $1 will lose value if the stock goes down, doesn’t move at all, or doesn’t make a dramatic move to the upside. Basically you can win three different ways.
Tomorrow, I hope to introduce selling a put spread, and Thursday I will combine these strategies into an iron condor.
We will watch these strategies’ reactions to JP Morgan’s earnings announcement on Friday to see how they would have performed.
Then starting next week, I’ll start issuing trade alerts using these strategies.