Best of the Week
Most Popular
1. 2019 From A Fourth Turning Perspective - James_Quinn
2.Beware the Young Stocks Bear Market! - Zeal_LLC
3.Safe Havens are Surging. What this Means for Stocks 2019 - Troy_Bombardia
4.Most Popular Financial Markets Analysis of 2018 - Trump and BrExit Chaos Dominate - Nadeem_Walayat
5.January 2019 Financial Markets Analysis and Forecasts - Nadeem_Walayat
6.Silver Price Trend Analysis 2019 - Nadeem_Walayat
7.Why 90% of Traders Lose - Nadeem_Walayat
8.What to do With Your Money in a Stocks Bear Market - Stephen_McBride
9.Stock Market What to Expect in the First 3~5 Months of 2019 - Chris_Vermeulen
10.China, Global Economy has Tipped over: The Surging Dollar and the Rallying Yen - FXCOT
Last 7 days
After 8 Terrific Weeks for Stocks, What’s Next? - 16th Feb 19
My Favorite Real Estate Strategies: Rent to Live, Buy to Rent - 16th Feb 19
Schumer & Sanders Want One Thing: Your Money - 16th Feb 19
What Could Happen When the Stock Markets Correct Next - 16th Feb 19
Bitcoin Your Best Opportunity Outside of Stocks - 16th Feb 19
Olympus TG-5 Tough Camera Under SEA Water Test - 16th Feb 19
"Mi Amigo" Sheffield Bomber Crash Memorial Site Fly-past on 22nd February 2019 VR360 - 16th Feb 19
Plunging Inventories have Zinc Bulls Ready to Run - 15th Feb 19
Gold Stocks Mega Mergers Are Bad for Shareholders - 15th Feb 19
Retail Sales Crash! It’s 2008 All Over Again for Stock Market and Economy! - 15th Feb 19
Is Gold Market 2019 Like 2016? - 15th Feb 19
Virgin Media's Increasingly Unreliable Broadband Service - 15th Feb 19
2019 Starting to Shine But is it a Long Con for Stock Investors? - 15th Feb 19
Gold is on the Verge of a Bull-run and Here's Why - 15th Feb 19
Will Stock Market 2019 be like 1999? - 14th Feb 19
3 Charts That Scream “Don’t Buy Stocks” - 14th Feb 19
Capitalism Isn’t Bad, It’s Just Broken - 14th Feb 19
How To Find High-Yield Dividend Stocks That Are Safe - 14th Feb 19
Strategy Session - How This Stocks Bear Market Fits in With Markets of the Past - 14th Feb 19
Marijuana Stocks Ready for Another Massive Rally? - 14th Feb 19
Wage Day Advance And Why There is No Shame About It - 14th Feb 19
Will 2019 be the Year of the Big Breakout for Gold? - 13th Feb 19
Earth Overshoot Day Illustrates We are the Lemmings - 13th Feb 19
A Stock Market Rally With No Pullbacks. What’s Next for Stocks - 13th Feb 19
Where Is Gold’s Rally in Response to USD Weakness? - 13th Feb 19
US Tech Stock Sector Setting Up for A Momentum Breakout Move - 12th Feb 19
Key Support Levels for Gold Miners & Gold Juniors - 12th Feb 19
Socialist “Green New Deal” Points the Way to Hyperinflation - 12th Feb 19
Trump’s Quest to Undermine Multilateral Development Banks - 12th Feb 19
Sheffield B17 US Bomber Crash 75th Anniversary Fly-past on 22nd February 2019 Full Details - 12th Feb 19
The 2 Rules For Successful Trading - 12th Feb 19 -
Financial Sector Calls Gold ‘Shiny Poo.’ Are They Worried? - 11th Feb 19
Stocks Bouncing, but Will They Resume the Uptrend? - 11th Feb 19
EURO Crisis Set to Intensify: US Dollar Breakout Higher
Stock Market Correction Starting? - 10th Feb 19
Gold Stocks Gather Steam - 10th Feb 19
Are Gold Bulls Naively Optimistic? - 9th Feb 19
Gold, Silver Precious Metals Update - 9th Feb 19
The Wealthy Should Prepare to Be Soaked - 8th Feb 19
US Business Confidence Is Starting to Crack - 8th Feb 19
Top Myths and Facts about ULIP Plans - 8th Feb 19
A Major Stocks Bear Market in 2020? - 8th Feb 19
Gold Market Extremes Test Your Mettle - 8th Feb 19
The Venezuela Myth Keeping Us From Transforming Our Economy - 8th Feb 19

Market Oracle FREE Newsletter

The Real Secret for Successful Trading

Using Double Calendar Options Spreads to Capitalize on Corporate Earnings

InvestorEducation / Options & Warrants Jan 19, 2011 - 10:17 AM GMT

By: J_W_Jones

InvestorEducation

Best Financial Markets Analysis ArticleIBM will reported earnings after the closing bell on Tuesday, January 18.  For traders maintaining a position in common stock during earnings releases and the frequent price gyrations can result in uncomfortable moments.

Earnings releases for the options trader do not force us to take a position in which we must correctly predict the direction of price action stemming from the earnings release. By exploiting the typical changes in option pricing that reliably and reproducibly occur as earnings approach, it is possible to establish a broad potential range of profitability that extends for a considerable distance both above and below the current price of the underlying.


The core point of understanding is to recognize that implied volatility (IV) reproducibly increases in the series of options that will expire after the impact of earnings has been reflected in the price of the stock. Using the standard option pricing models, IV is directly correlated with option prices being “rich” or “lean”. In the specific case under consideration, IBM monthly options will expire this Friday, January 21. A further predictable characteristic of this IV increase is that this juiced IV will drop substantially and rapidly following the release of the earnings and the reaction of price of the stock to this event.

Armed with this knowledge of the characteristic behavior of IV, let us consider a trade to exploit this predicted sequence of events.  The trade structure we will use is that of the “double calendar spread”. This spread is established by selling the front month options with the juiced IV and buying longer dated options with lower IV. The fundamental rationale for this trade is that we are going to sell “rich” option premium and buy normally priced premium.

As a first step, consider this option pricing matrix for IBM from this morning (IV is labeled MIV in this proprietary software):

As highlighted by the ellipses and horizontal arrows, it is clear that the predicted increase in IV has occurred and there currently exists a horizontal volatility skew.

The next step in understanding this trade is to check to be sure the historic range of volatilities which are typical for this underlying.  Below is an embedded daily chart of the implied volatility. When considered together with the first chart of current pricing, it is clear that we are selling rich premium and buying more normally priced premium.

With this understanding, we can now consider the performance graph of this double calendar trade. It is constructed with four individual legs which are executed by “buying” two individual calendar spreads. It should NOT be executed in four individual trades. The specific trades are to sell the January 155 calls, buy the  February155 calls, sell the January 145 puts, and buy the February 155 puts.  The expected performance graph is embedded below:

As can be seen from the graph, the trade has breakeven points of 139.98 to 159.30.  The magnitude of the predicted move can be imputed from the price of the at-the-money option straddle. That analysis gives a range of 145.90 to 154.10, price values well within the profitable zone of the trade.

What are our points of risk on the trade? Risk comes from two sources in a trade such as this: price and IV. If price exceeds our breakeven points, the trade will be unsuccessful. If IV of the long legs collapses more than projected, the trade will produce losses. Risk is crisply limited to the amount paid for the trade; you cannot lose more than the capital invested.

This is an example of a controlled risk trade seeking to capitalize on well recognized relationships between an earnings release and option pricing. This is not a “gimmee” trade, but represents a reasonable risk:reward situation. As with all trades, it is presented for educational purposes only and does not constitute a recommendation.

If you would like to continue learning about the hidden potential options trading can provide please join my FREE Newsletter: www.OptionsTradingSignals.com 

 J.W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis. J.W. strives to reach traders that are missing opportunities trading options and commits to writing content which is not only educational, but entertaining as well. Regular readers will develop the knowledge and skills to trade options competently over time. Jones focuses on writing spreads in situations where risk is clearly defined and high potential returns can be realized. 

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.  


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules