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Last week we discussed some of the fundamental
concepts necessary to understand both the behavior of options in the approach
to earnings release and their reaction to the actual release itself. Our
example was AAPL which indeed reported disappointing earnings on Tuesday,
July 24.
We
reviewed the fact that because of the risk associated with these events, many
traders use options to define their risk and protect their trading capital.
We posited three trades: bullish, bearish, and agnostic. I thought it would
be instructive to return to those trades and assess how each would have
performed for our hypothetical trader.
A major
concept to understand in dealing with options is the behavior of the implied
volatility. For the sake of review, let’s return to AAPL’s option
board we discussed last week; the montage is posted below:
AAPL
Option Chain
Note the
implied volatility for the 605 strike call for not only what was the then
front series ahead of earnings, but also for the entire series of options at
this strike extending into the September series.
Now let us
look at the current quote board and see the impact of earnings having been
reported and removal of the uncertainty surrounding the impact of that event.
The current quotes are below:
AAPL
Weekly Option Chain
The
collapse of implied volatility is clearly seen here. The at-the-money strike
volatility has shrunk to around one-third of its previous value!
Astute
readers may be confused by the two different strikes chosen to assess the
volatility levels in each of the two examples above. In the quotes from last
week we used the 605 strike options and the current table uses the 585
options. Why the difference?
In order
to make an apples-to-apples comparison, we will always use the current
at-the-money options. This convention exists in order to minimize the effect
of any volatility skew which may exist between the variously available
strikes. Last week that was the 605 strike and this week it is the 585
strike.
Now let us
take a moment to review how well the option volatility predicted the
magnitude of the price movement. Remember that the formula for calculating
this prediction is the average of the front series straddle and the first
out-of-the-money front series strangle. In our example, this calculation
provided a value of $31.50.
In
Tuesday’s regular session, AAPL closed at $600.92. It had an intraday
low on Wednesday of $570.00, or a decline of $30.92. I think this is a quite
remarkable performance for an easily calculable value. Over a large series of
individual predictions, this calculation has around 68% accuracy in
predicting the size of movement on earnings.
Now
let’s return to our theoretical trades described last week in an
attempt to see what we did right and what we did wrong:
Our
bullish trade was a call debit spread; the specific structure and projected
P&L is graphed below:
 
AAPL
Trading Profit/Loss
This trade
does not warrant a lot of discussion. It was a directional trade and the
direction was wrong. All the options would have expired worthless at the bell
on Friday and the trader would have suffered a loss of the entirety of the
cost of the position.
The
bearish trade was a put debit spread:
AAPL
Bearish Put Debit Spread
This
spread reached maximum profitability at the bell on Friday since the short strike,
595, was never challenged following earnings. This spread was purchased for
around $2.20 and reached its maximum value of $5.00 for a return of roughly
127% on maximum risk.
Finally,
the Iron Condor we discussed had a broad range of profitability and reflected
the expectation that AAPL would move no more than 1.5 X the predicted
move:
APPLE
Option Trading
This
condor could have been sold for a credit of around $1.06. The $1.06 sum
represents the maximum potential profitability of the trade. Because both
short strikes remained out-of-the-money, it achieved this maximum
profitability and would have been allowed to expire worthless on Friday.
Return on maximum risk was the strike width of the wings, $5, less the
initial credit received ($1.06), or $3.94. This represents a return of 26.9%
on maximum risk.
These
three trades looked at three examples of trading AAPL earnings using
strategies with defined risk. The all or nothing approach is exemplified by
the directional approaches and is similar to strategies available to stock
traders.
Our Iron
Condor with a broad range of profitability with a lower potential profit, but
high probability of profit is an example of a typical options based approach
to earnings trades. I welcome questions and invite you to try our service at
OptionsTradingSignals.com to gain more insight into some of these strategies.
JW
Jones
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