All The Right Option Moves: Take The Improv Out Of Earnings

The Lindy Hop, the Running Man, and the Macarena are all child’s play to an option trader who likes to stay a few steps ahead of the market, right?

When it comes to moves, you’ve got ’em all—except maybe the shuffle around an earnings announcement. Let’s call earnings the free-form dance of the stock market. Sometimes you nail it, and sometimes you flop.

Don’t feel too bad; even Dionne Warwick’s Solid Gold dancers or her psychic hotline can’t tell you which way to two-step around an earnings announcement.

But there are option market moves designed to improve the odds that when a stock zigs around earnings, you don’t zag—unless, of course, your strategy calls for a zag! How? Some traders like to use straddle/strangle swaps to play earnings announcements, using strategies and tools to help navigate these sometimes vexing volatility events.

In a recent article we talked about how stock-only traders might look to earnings-linked options action for an indication on the scope of the underlying stock move. Here, we’ll dig in to the options strategy itself.

Elements of Your Move

A straddle/strangle swap (SSS) is a delta-neutral strategy, which means you expect the price of the underlying stock to stay within a certain range. The SSS consists of two short options and two long options of a different expiration. The short options are no more than two weeks from expiration, so this strategy is usually limited to stocks with weekly options. The long options expire a few weeks later than the short options. That’s because the options with the shorter expiration will have higher implied volatility in anticipation of an earnings announcement.

Figure 1 shows the volatility skew where a stock that is one day from an earnings announcement has the shortest options with exceptionally high implied volatility. This contrasts with the later options, where implied volatility is much lower. The expectation is that after the earnings news hits, those short-term volatilities will return to the same range as the later volatilities.

Next: Composition

Here’s a sample: The short options are calls and puts sold at the money. This approach offers the highest premiums, meaning the money you collect for selling an options contract. Using the example in figure 1, a trader might choose to sell the at-the-money options for MAY15. The MAY2 options may not have big enough premiums to make the trade worthwhile—plus, you’d only have one day to dance.

When selecting long options, a trader might pick those that are less likely to have any change in implied volatility, but are also less expensive. It appears from figure 1 that “normal” volatility is probably in the mid-40s. So, let’s look at the JUN2. Figure 2 shows us a calculation that uses the stock price, implied volatility differential, and time to expiration, equaling a plus/minus 3.30 (or just over 3% move in either direction). You might choose the long call by subtracting this figure from the at-the-money strike. The price of this stock is $39.84, so the at-the-money strike would be 40. Round down to the nearest strike price, in this case 36.50. Now, to select a long put, add the 3.30 plus/minus move to the at-the-money strike and, in this case, round up to the 43.50 strike.

Choreography: Put It All Together

Of course, the climax will come after the earnings announcement, but we can get an idea of what we might expect to see after the event takes place. Figure 3 shows the steps to adjust the implied volatility for MAY15 down 30 percentage points. This was a guess for what it might be when options return to “normal.” The trade would’ve cost about $413, plus commissions and fees, and hypothetically turned into a profit of about $82.

The risk-to-reward ratio might look a little off. However, the $413 accounts for margin on two sides of a trade that can technically only go one way. What that means is that unlike other multi-leg spreads, the SSS is required to carry margin for both the bullish side and the bearish side even though the stock price can only go up or down. However, we're still assuming that there's a good chance the stock will move, period, which is what we care about.

Figure 4 shows the risk profile for this trade. The stock price must stay between the red dotted vertical lines in order for the trade to be profitable. Keep in mind that another concern could be falling implied volatility in the long option, which could offset any gain in the short option and result in a loss.

Parting Ways

Once the song is over, so is the dance. We aren’t starting a romance here.

After the earnings announcement takes place, there’s no reason to stick around. Consider closing the trade for a profit or loss and looking for a new partner.

This piece was originally posted here by Ryan Campbell of Investools on June 11, 2015.

TD Ameritrade, Inc., member FINRA/SIPC. Commentary provided for educational purposes only. Past performance of a security, strategy, or index is no guarantee of future results or investment success. Inclusion of specific security names in this commentary does not constitute a recommendation from TD Ameritrade to buy, sell, or hold.

Options involve risks and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before investing. Supporting documentation for any claims, comparison, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.