Most Popular
1. Banking Crisis is Stocks Bull Market Buying Opportunity - Nadeem_Walayat
2.The Crypto Signal for the Precious Metals Market - P_Radomski_CFA
3. One Possible Outcome to a New World Order - Raymond_Matison
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
5. Apple AAPL Stock Trend and Earnings Analysis - Nadeem_Walayat
6.AI, Stocks, and Gold Stocks – Connected After All - P_Radomski_CFA
7.Stock Market CHEAT SHEET - - Nadeem_Walayat
8.US Debt Ceiling Crisis Smoke and Mirrors Circus - Nadeem_Walayat
9.Silver Price May Explode - Avi_Gilburt
10.More US Banks Could Collapse -- A Lot More- EWI
Last 7 days
Stock Market Volatility (VIX) - 25th Mar 24
Stock Market Investor Sentiment - 25th Mar 24
The Federal Reserve Didn't Do Anything But It Had Plenty to Say - 25th Mar 24
Stock Market Breadth - 24th Mar 24
Stock Market Margin Debt Indicator - 24th Mar 24
It’s Easy to Scream Stocks Bubble! - 24th Mar 24
Stocks: What to Make of All This Insider Selling- 24th Mar 24
Money Supply Continues To Fall, Economy Worsens – Investors Don’t Care - 24th Mar 24
Get an Edge in the Crypto Market with Order Flow - 24th Mar 24
US Presidential Election Cycle and Recessions - 18th Mar 24
US Recession Already Happened in 2022! - 18th Mar 24
AI can now remember everything you say - 18th Mar 24
Bitcoin Crypto Mania 2024 - MicroStrategy MSTR Blow off Top! - 14th Mar 24
Bitcoin Gravy Train Trend Forecast 2024 - 11th Mar 24
Gold and the Long-Term Inflation Cycle - 11th Mar 24
Fed’s Next Intertest Rate Move might not align with popular consensus - 11th Mar 24
Two Reasons The Fed Manipulates Interest Rates - 11th Mar 24
US Dollar Trend 2024 - 9th Mar 2024
The Bond Trade and Interest Rates - 9th Mar 2024
Investors Don’t Believe the Gold Rally, Still Prefer General Stocks - 9th Mar 2024
Paper Gold Vs. Real Gold: It's Important to Know the Difference - 9th Mar 2024
Stocks: What This "Record Extreme" Indicator May Be Signaling - 9th Mar 2024
My 3 Favorite Trade Setups - Elliott Wave Course - 9th Mar 2024
Bitcoin Crypto Bubble Mania! - 4th Mar 2024
US Interest Rates - When WIll the Fed Pivot - 1st Mar 2024
S&P Stock Market Real Earnings Yield - 29th Feb 2024
US Unemployment is a Fake Statistic - 29th Feb 2024
U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - 29th Feb 2024
What a Breakdown in Silver Mining Stocks! What an Opportunity! - 29th Feb 2024
Why AI will Soon become SA - Synthetic Intelligence - The Machine Learning Megatrend - 29th Feb 2024
Keep Calm and Carry on Buying Quantum AI Tech Stocks - 19th Feb 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

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.  


© 2005-2022 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