Dr. Lawrence Silverberg is a star Level 3 traders, and good friends in the business. He used to guest blog at my old site all the time. I thought it was high time to get him back to blogging for our readers. He is a prime example of the type of students we attract for our Level 3 Mentoring course and what we expect our Level 2 Mentoring students to become. If you have any interest in working with myself or Lawrence, check out Option Pit Mentoring Services. For more of Lawrence's blogs check out VolTrader Blog
Today I’d like to discuss the anatomy of an earnings trade. I will walk you through my thought process and research that goes into putting on a trade before earnings.
First, I scan for the trade. My first stop is the LiveVol Pro Software. There are many different scans that I use on the platform. There is a whole section for earnings scans:
This is how I use the scans: I find an underlying and look at the Charts tab and plot the implied volatility (IV) of the front and back months and look for elevated IV compared to historic IV. Then I switch to the Skew tab and look for horizontal (month to month) and vertical skew (between strikes, same month).
Today, I found OTEX in my scan for “Pre earnings IV30 Day Gain”. * IV30 = Click here to see LiveVol’s definition and scroll down to ‘Calculation Methogology’. (Note, this example is for demonstration purpose only and I would normally not trade OTEX as it is too illiquid to get good fills and has wide bid-ask spreads but it makes for an excellent example.)
Looking at the Charts tab I noticed that the front month IV was very high going into earnings. Chart below is one year plot of IV30:
Next I switch to the Skew tab and look for skew. Below you can see the Aug options (red line) are clearly elevated above all back months but this is a little deceiving. Aug expiration only has 3 days to go. I would never sell these options as they are too risky although they look like a wonderful skew to sell in this chart. Notice Sep (Yellow line) is also above the other back months. That is where I want to sell elevated premium.
When I remove the (Red) Aug options in the chart below, it is evident that Sep is also elevated. Here, I have decided I want to sell Sep and buy Jan11. That is the horizontal skew or term structure I want to trade. Next we’ll pick strikes.
I want to sell the elevated IV $35 or $40 Sep options and buy the Jan11 options to hedge.
Now I set up a diagonal in Thinkorswim and analyze it. I chose to sell the Sep $35 calls and buy the Jan11 $40 calls and choose a ratio that I like. I chose the ratio in order to create a trade that suits my market outlook on the underlying price and the volatility. Using some technical analysis (moving averages, volume profile of support and resistance and overall market trend) I chose a bearish trade with recent overhead resistance at $40-$41 and long term, two year chart, support at $35 and lower at $31. Once I have my underlying predictions I want to predict IV moves. Of course I think there will be IV crush of the Sep options after earnings and a much smaller decrease in Jan11 options. The Jan11 options will likely lose a little IV if the underlying stays the same or goes up and while the Sep options will lose IV if the underlying goes down, Jan11 will likely increase in IV with a decrease in share price as longs buy these puts for protection.
First I looked at a 1:1 Sep $35call / Jan11 $40 diagonal with OTEX trading at $37.18 which looks like this:
Clearly I will be good if the underlying moves down as direction and vega will help as described earlier and risk is to the upside. As those Jan11 options lose on direction and decreased IV the upside will be very bad. I next think how to protect losses to the upside. Selling puts is the first thing that comes to mind as that will produce long delta and short vega but will hinder the downside profit. The OTM Sep $30 puts don’t have enough premium to sell at $0.15x$0.20 so that leaves selling ATM $35 puts. I chose to sell 4 contracts by looking at the P&L chart and seeing where it moves my breakevens and how it decreases my delta and Vega. It now looks like this:
Remember my support at $35 and $31 and overhead resistance at $40-$41 comes out to a nice profit on the downside and a tolerable loss on the upside.
Note: I can anticipate the following question: That chart looks a lot like a $35 calendar spread. Below is a comparison of the diagonal plus short put (white line) vs. the Sep $35 / Jan11 $35 calendar (30 contracts) (red line) that produces similar max profit. As you can see the upside is very similar but the benefit is to the downside.
I put this trade on as a paper trade this morning (18-Aug-2010). As I indicated above, even on paper I didn’t get great fills as the options are illiquid.
Exit strategy: Right after I put the trade on the underlying moved down a little and the trade was up $420. I didn’t close any spreads but if there is a bigger move down prior to earnings I will look to take half off if I have an $800 or more profit thus reducing post earnings risk.