Earnings Trades Part I - Good Trade

The third quarter earnings cycle just concluded couple weeks ago. In this two part post, I'd like to reflect on  some of my earnings trades - the good ones :-)

An earnings cycle which typically occurs four times a year, for four quarters, presents a good opportunity for premium sellers to get engaged and gain some money from the increased IV.  

We are living in a low volatility environment (with VIX hovering at a range of 10 to 12 for a good part of the year). Unfortunately, in a low volatility environment the opportunities for us premium sellers to be successful is extremely low.  

Here is my go-to recipe for earnings trades:

• I try to stay delta neutral as far as I can.  Being delta neutral means that I don't have any directional bias even if stock goes up or down after an earnings announcement. I can never truly have a good sense or intuition about the direction of a stock, as I cannot predict how the stock will move after earnings.  The nature of the announcement has no bearing on direction. A good announcement can dip the stock price while bad news could send the stock soaring high.
• However, there are times when I do take a directional bet on the stock and go long or go short. My directional assumptions are not predicted by any technical or fundamental analysis, but rather dictated based on my portfolio's beta-weighted delta (to be further explained in future post). (As you might be noticing, delta is key) At a high level, my beta-weighted delta tells me the impact a one dollar move in the stock market would have on my portfolio.  So if, for example,  I currently have a huge negative beta weighted delta and if a highly correlated stock, like GOOG, AAPL, AMZN, were to be announcing their earnings, I might take a position in direction opposite to my portfolio. That is, I'll neutralize my negative deltas in portfolio by adding some positive deltas (or going long) in GOOG or AAPL, or AMZN.
• Watch the IV numbers across the different options cycle. The nearest options chain would have a really high IV compared to the subsequent option chains later in time. This difference between front and back option cycle can give you an idea of how inflated the IV is. The whole game is to sell inflated premium prior to announcement and buy it back after announcement once the IV collapses.
• I never buy premium going into earnings (as studies and research done by TastyTrade has shown that it's something that'll never work over a long haul). While there may be a few successes here and there, I don't consider it a sustainable strategy.
• In terms of money management, I try to stay small, with none of my positions exceeding 2% to 5% of the portfolio size. Given various accounts, strangles are naked/uncovered positions which have theoretically undefined risk and can't be placed in a retirement type account. The buying power reduction of one naked put is around 20% of the price of the stock. So, if NFLX is trading at $160, one short put would need a buying power of about 20% of $16,000 which would be about $3,200. Adding an extra short call wouldn't increase the required buying power as the risk is only one sided. So one can view the buying power reduction on a short strangle as around 20% of the stock price (might vary slightly given the volatility, market conditions, interest rates etc, but it's a good rough estimate to use) For these reasons, I try to stay small in my positions. 
• My favorite delta neutral strategy is to sell strangles at one standard deviation. That is, sell a 16 delta call and sell a 16 delta put in the option cycle nearest to the earnings.  While all the research on TastyTrade has shown that the 16 delta option provides the best bang for my buck, during earnings I like to go a little further away primarily for two reasons:
  • by going further away from 16 to 10 delta, the buying power reduction is a bit less
  • in my experience 16 delta positions would need a lot more active management, which is not easy during the school year :(
• The "MMM" market maker move on the TOS platform gives a quick and easy reference number that's a one standard deviation expected move (this can also be easily calculated! - see earlier post on this topic).  Given the "MMM" number, I like to add 25% or 50% buffer and sell strangles.

Here are a  couple of trades from this earning cycle. Please click on the image to see details of the trade:

GOOGL Iron Condor: $0.60 profit

FB strangle: $0.68 profit

ADBE Strangle: $0.85 profit

FDX Strangle: $0.76 profit

LULU Strangle: $0.94 profit

I've posted 5 successful earnings trades above. Or as Tom (at TastyTrade) would call it "winner, winner, chicken dinner".
That was easy, right...?  Well, not so fast. 

Things worked out well on these trades, but there are trades that don't always go the way you'd like them to. That's why  the topic of this blog post is 'Good Trades'! 

In the next post, I'll highlight some 'Bad Trades' and show how I try to repair trades gone astray. 

Thank you for reading! :) 
-Nisha