Fujisan’s Naughty Spreads: IV Rush

I’m proud to present our first installment in a series of option spread strategy tutorials presented by our lovely Fujisan (part 1- hitotsu me):

Thank you so much for letting me share my strategy in your site.  I’m very thrilled with this opportunity to help out other traders.

As we are in the middle of earnings reason, a lot of people are trading options for earnings play.  Have you ever experienced picking the right direction on an option and yet you didn’t make any money or even lost money in some cases? That is all due to IV (Implied Volatility) rush.

As you know, option pricing is affected by theta (time value), delta/gamma (magnitude of price movement), and vega (volatility).  Toward the earnings release, many people start betting on the direction of underlying stocks with options, and this activity inflates the value of options through vega and this is called “IV Rush”.

Here is a screen shot of RIMM’s IV right before the earnings on April 2nd.  Note that RIMM’s IV is close to 100% (99.46%, to be exact).

Here is another look of RIMM’ IV right after the earnings on April 3rd.  There’s a pretty obvious drop of IV from 100% to 73.74% – almost by 30% overnight?

Here is what this 30% drop in IV would do to your position.

Let’s say that you have put ATM (at the money) 55 straddle (straddle is a combination of naked puts and calls with same strike price) on RIMM right before earnings.

Here is a look after earnings:

Do you see a major plunge after earnings?  This is because the options were unreasonably inflated due to IV rush.  The same happens with ATM reverse calendar (sell calendar spread – calendar is a combination of calls or puts with same strike price with different months) as well.

Here is a reverse calendar spread before earnings:

And after the earnings:

Do you get my point?  This is the reason why it’s so tough to make money during earnings with options.  But is there any way that we can make money consistently on earnings?

Yes, there is a way, but it’s not what you expect.  I know many of you like to double or triple the money in one shot over earnings, but that does not happen often.  If you like to be a good trader who bring in a consistent result, here is how you play with earnings.

You pick the stocks with a good positive skew (i.e., front month IV is much higher than the back month IV – as I showed you above with RIMM).  Buy an ATM straddle 3~4 days before earnings, but do not buy one after Tuesday/Wednesday as you don’t want to burn extra theta over the weekend.  This means that you could only pick stocks with earnings announcements from Wed through Friday.  Hold on to your position up until earnings and close your position.  This is a pure IV play with delta neutral position.  You expect your ATM option to be inflated so that you can take advantage of IV rush.

The average profit range of this type of trades is roughly 5 – 20%, but it’s not bad at all if you can make 5-20% over 3~4 days with delta neutral position.

If you like to give it a try, please paper trade it first and get the feel for this type of trade.  If you decided to put it in the actual trade, don’t risk more than 1-5% of your total capital.

There is one more way to play with earnings and this is my favorite through OTM butterfly.  This strategy works the best if the earnings release is right on OPX.  GOOG would be the perfect example for this and I could go over the real example once we get close to GOOG earnings.

UPDATE: Due to popular demand I’m posting a little treat: Geithner’s Scheme To Rip Off Taxpayers 2.0: