Wednesday, October 18, 2006

Vol Risk: Strangles Before Earnings

The title really says it all and most of the traders who have lost enough money in the game know how vol risk works. However, it is nice to be reminded of it every so often.

Case in point being last night's IBM earnings.

As the sentiment was so upbeat and the stock quite overextended the obvious thing to do was to buy the 85/90 strangle. Historically, post-announcement the stock would either pop a lot higher or drop like a stone. Either of these things tended to happen quite reliably when the stock ran up or down into earnings and peaked on volume.

Since I like scalping gamma we put on a synthetic by buying Nov 90 calls and selling the stock. With the stock trading at 87.50 towards the end of the day, buying 30 calls per every 1000 shares sold short resulted in a perfect delta neutral position. So, any appreciable move in the underlying would result in long or short deltas automatically banking us a profit. Simple, naive and actually workable.

Of course I looked at the vol of the calls prior to buying and found it at 21 - above the mean of 17. So, the vol risk was there and it was quite probable the vol would implode post-announcement.

I just didn't think it would implode to 16.

So, when IBM opened at 90.60 the strangle should have resulted in a nice profit - had the vol stayed near the 19-20 level. Instead it actually lost money - not a lot - but enough to be reminded that vol risk is very real and is to be respected. Knowing what I always knew about this (trading 101) this morning made me feel like a little boy.

The stock did end up running to 92 and thankfully the strangle made money by the time it had crossed the 91.10 barrier. So, shedding the "little boy" image and turning into a temporary daytrader I scalped the slowly emerging delta as the stock got taken higher.

A nice profit overall, but a sobering lesson nonetheless: making money on this strangle shouldn't have involved my stock trading skills.

Bottom line: if you play long gamma/vega prior to an announcement, don't assume your vega exposure won't do you in. So, hedge it. And if you don't know how then don't put on the strangle.



At 3:40 PM, Anonymous Anonymous said...

Just pondering, but why not just take an outright option position on IBM before earnings. I figured, there's a 33% chance of picking the correct move and making money without even thinking. There's that 33% chance that picking the calls will make money, 33% that picking puts will make money, and 33% chance that picking either will lose money due to IV crush, and uncertainty disappearing right? By any chance, how much profit did you capitalize on that IBM trade? Just wondering because my indicators pointed to a 65% chance that IBM was going to present a very convincing report and that is should move higher.

At 7:12 AM, Blogger Q1 said...

No November updates? Whazzup?


At 2:53 PM, Blogger Paul Auen said...

Interesting comment above. A long option position is a 33% guess at the direction. The straddle / strangle strategy now puts you at a 66% chance of picking the right direction. The stock just needs to move somewhere.

But I believe the point of the original post was that even picking the right direction doesn't mean a profitable trade. The volatility in the options can sometimes inflate (high vol) or deflate (low vol) the premiums faster than a move in the stock.

I had a recent straddle position on a drug stock (CBRX) waiting for a clinical trial result. You can review it at

Montgomery, AL
Stock Trading - My Way


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