Selling Strangles Prior to Earnings

Hi Mark,

What is your opinion on a short strangle vs a short straddle?

I understand the same unlimited risk will be there because you are trading naked options. I found that one strategy I have had some success with in paper trading is using short strangles around earnings to take advantage of large drops in volatility. I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play.

Steve B

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Hi Steve B,

1) To me they are the same, with the straddle being a subset of the strangle  In other words, a straddle is merely a strangle when the strikes and expiration dates are the same.

I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike.  I prefer to sell OTM calls and puts – and that's not possible with a straddle.

As far as unlimited risk is concerned, that's a decision for each trader.  I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post.

2) A clarification.  In is not 'volatility' that incurs a large decrease after the news is released.  Instead it is the implied volatility of the options.  I'm fairly certain that is what you meant to say.

3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be.

4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news."  The market has made an estimate of how much the stock price is likely to move.  Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated.

There is no formal prediction of move size.  There is nothing that says the stock will move 6.35 points.  What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options.  And it makes no difference if they are calls or puts [See last year's post: puts are calls; calls are puts].  At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured. 

From the IV, the 'anticipated move' for the underlying is determined.  AsI said, it's not as is everyone agreed on how much the stock will move.

I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move.  Many times the move is far less than expected.  That's the reason why selling options prior to earnings can be very profitable.  The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts.

However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV decrease doesn't do a whole lot of good.  Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money.

Also remember that part of the time thet stock price gaps by far more than expected.  In that scenario, a higher quantity of formerly OTM options are now ITM.  Thus, large losses are not only possible, but they are more frequent that you realize.  Apparently your trades have worked out well (so far).

Think about this:  If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago.  The truth is that these option buyers collect often enough to keep them coming back for more. 

5) That means you must be selective in which options you sell into earnings news.  This is especially true when you elect to sell naked options.  You cannot options on every stock, hoping that any random play will work.  This is a high risk/high reward game.  It's okay to participate, but please be aware of what you are doing and the risk involved.

827

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7 Responses to Selling Strangles Prior to Earnings

  1. TylersTrading 11/05/2010 at 10:15 AM #

    Hey Mark,
    Nice review of the dynamics of short strangles. For what it’s worth, I’ve found the easiest form of risk management when selling strangles lies in position sizing. Since the max risk is unknown, small positions are prudent.

  2. Mark Wolfinger 11/05/2010 at 10:28 AM #

    Tyler,
    Right. Position sizing is always the primary risk factor to be considered when making a trade.
    Thanks

  3. Steve B 11/05/2010 at 10:41 AM #

    Thanks Mark!
    Yes, I meant implied volatility, I apologize for not clarifying. I also understand that the market cannot know exactly the move the stock will make after earnings, but some moves can be priced into the market per se. I just meant to say that if positioned correctly, the movement in price will not offset the decline in IV because some of the price movement was expected to some degree. When I perform these trades, I try to sell OTM stocks 10-15% OTM from the current strike price. I will also look at historical earnings to see the stocks pattern for behavior before entering into a trade. I realize by creating such a large band I am taking smaller credits but I am also allowing for a further move of the stock before the options become ITM. But this also allows me some comfort in knowing that even larger than expected move one way or another will still provide me time to close the trade before it gets totally away from me.
    And as Tyler said, positions sizing is absolutely critical.
    Thanks again for the post. It is a great explanation of the pros and cons to this strategy.

  4. Steve B 11/05/2010 at 10:44 AM #

    Further clarification… by pricing some moves into the option, I just mean the market is not thinking the stock will stay flat so the move one way or another does not have the same affect as an unexpected move.

  5. Mark Wolfinger 11/05/2010 at 11:32 AM #

    Steve B,
    If you always sell options 10 to 15% OTM, then you must be certain you can recognize and avoid situations for which ‘the market expects’ a 20% move.
    You are selling options, hoping the stock doesn’t move enough to result in a loss. That is a reasonable strategy, when the trade size is appropriate for your account. This assumes you want a high risk/high reward strategy.
    However, the true test is: can you truly act ‘before it gets away’? Many traders have a huge difficulty pulling the trigger to lock in losses.

  6. JV 11/05/2010 at 11:47 AM #

    Just my opinion. Be very selective on strangle selling with the earnings. I made money 5 times straight with this method and got too complacent and sold on a company that did not have high volatility going in. This play promptly turned a potential $2,000 gain into a $7,500 loss.
    Mark,
    A question for you. I sold a Nov IC in early Oct which included a RUT 750/770 spread. Delta is climbing more everyday and with 2 weeks left and 16 points between current and short strike I’m trying to decide the best route to save this with the least amount of red. On the potential reversal side, volume is dropping on RUT, A/D line is over 200, and RSI is through the roof.
    So some professional feedback would be great. Here are my current thoughts.
    1) Close down shop and possibly roll up to higher strikes next week for less credit.
    2) Close half the position for now and open additional contracts next week farther out.
    3) Roll all 750 shorts up to 760 which is 10 points above April high.
    4) Wait it out and pray. Least likely scenerio.
    5) Move half shorts to 760 and the other half to 780 and keep longs open.
    6) Buying back a few shorts.
    7) ??????????
    Thanks for your feedback.

  7. Mark Wolfinger 11/05/2010 at 12:27 PM #

    JV,
    Agree with being careful. This ‘attractive’ strategy is truly risky.
    I can provide feedback on trade ideas, but have no clue whether we are going to move higher or lower.
    This is a good topic and I will use it for a blog post next week.
    However, I know you want an answer right now, so will send that via e-mail. Look for it.
    Regards