With another round of quarterly earnings under way, it feels like a good time to talk about an option strategy that revolves around the expected volatility event. The great thing about options is that there are a variety of ways to profit with them depending on the outlook and strategy. At Market Taker Mentoring, we have a whole system for trading earnings based on time spreads that is quite effective. But there are other strategies to consider as well.
A straddle is buying a call and a put option that share the same strike with the same expiration. The spread can profit from a move higher or lower because of the long call (bullish) or long put (bearish). This, of course, cannot be done with an equity position because a long and short stock position would cancel each other out. But if you have ever held a long straddle over an earnings announcement, you have probably witnessed the effects of implied volatility whether you realized it. Let’s take a look at how we can put volatility to work for us.
As a general rule of thumb, option prices tend to increase as a volatility event like earnings approaches. The implied volatility rises because there is an expected move related to the announcement. After the earnings release, implied volatility and option prices tend to revert to the mean and immediately drop right afterward. This is why a long straddle will lose money if the stock does not gap enough to overcome the volatility crush the next trading session. But what if the trade is exited before the announcement?
Implied Volatility and Option Vega
The general idea of this pre-earnings straddle is to profit from either positive or negative delta, an increase in IV or both. Although past performance is not indicative of future behavior, you would like to find a stock that has a history of price volatility ahead of the announcement. Generally, looking at the previous four earnings should give you an indication. As the earnings date approaches, the IV of the options should increase. This is what you plan on capturing in regards to profit, the stock moving a decent amount in one direction and at the same time the option premium increasing due to the rise in implied volatility.
The position has positive vega due to the long call and put. Vega increases the premium for every 1% increase in IV (it decreases the premium for every 1% decrease as well). So, if IV increases for the options, the premium should also increase. Putting on this position should be considered anywhere from about two to four weeks before the expected earnings announcement.
As I like to say in Group Coaching class, there is always a trade-off when trading, whether it be risk/reward or probability. The trade-off here is expiration. The closer the expiration is to the announcement, the more you can expect IV to increase along with the premiums. The downside is negative theta will be bigger and work to offset the IV increase. The position has negative theta due to the long call and put. Theta decreases the premium for each day that passes. The farther out an expiration is chosen, the position will have a smaller negative theta but will not enjoy as big of an IV push higher as the expiration that takes place closer to the announcement.
I personally like to choose the expiration that takes place two or three weeks past the announcement, but experimenting with both scenarios may be worth your time. Consider exiting the position ahead of the announcement or maybe when a profit or risk level has been met. Certainly, the position can be held over the announcement, but the added uncertain risk should be considered. If you are in my Group Coaching class, we will talk about several of these opportunities in the coming weeks.
Senior Options Instructor
Market Taker Mentoring, Inc.