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Fujisan’s Naughty Spreads: IV Rush
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Fujisan’s Naughty Spreads: IV Rush

by The MoleApril 4, 2009

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:


About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at the usual social media waterholes.
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  • http://www.triathlontrading.com TriathlonTrader

    The straddle is exactly what I had in mind. 🙂

    that is great analysis. thank you for sharing.

  • Bartholomy

    Hi my evil folks …
    I have been silent for a long time, but I was still there as a reader.
    Mole and all rats as usual great work and discussion, very profitering.
    Nice intro Fujisan, thanks too.
    I decided to log myself inside disqus, since your are a family for me.
    Here some info, I got :
    Economic data are getting worst… but official numbers do not say so.
    1. Banks are not profitable, they change the law, so the actual lost are NOT currently reported.
    2. Annonced grow of 3.4% is unexistant, it have been mathmetically tweak to get so, they real value is someting around -5%. (ref : David Rosenberg of Merrill Lynch)
    3. Year to year grow is -29%.
    4. Japan exportation dropped 49%
    5. New building fields are not 583 000, but 50 000 only.
    6. Number of americans that can afford a home and are not homeowner : 10 million
    7. Domino effects… all big american compagny hold bond from other… once one big is collapsing (think of GM) look the domino effect (this is why AIG have been saved).
    How many big US comapgny have GM bonds ? etc..?
    8. Unemployement levels is really worrying
    9. Culural consommation is changing
    10. I don't see any good profits coming for now, saving will be the new trend
    11. Next earning should be disastrous

  • slartybardfast

    Fujisan, This is awesome. Clearly explained and succinct. The screenshots make it so much easier to follow. I'm going to give this strategy a try for sure Thanks for the tips, I'll let you know how I go. You only truly lean in the end by doing, right?

    I hope you will continue to do these posts whenever you can, it is really helpful. Good idea to do this, Mole.

  • slartybardfast

    http://www.youtube.com/watch?v=n-arbfLTCtI

    This is a brilliant and simple explanation of Geitner's current plan. Towards the end of the video you will see that there are loopholes built in, so that banks can swindle hundreds of billions of taxpayer dollars without any kind of congressional approval.

    Credit to GMuni, who posted this information earlier in the week. I think everyone should see the video, so I thought a weekend re-post was warranted.

  • GoCougs

    Awesome post! Thanks for all the help fuji! Can you define front month vs. back month IV?

  • Duuuuuude

    This is the best traders community period. Thanks Fujisan and all contributors.

  • maybesomeone

    What is the best way to find these high IV options? It sounds like it's to look for popular, volatile stocks before their earnings hit, and then go from there…

  • Osso

    Projecting SPX to 850. Then….pullback (38 to 62%)…probably to 758. From there…up to 1055.

  • Harmon

    (GE) Update for those that trade it
    I am also working with the ISEE data in developing some oscillators
    Anyone that has done similar work your input would be greatly appreciated

    http://traderharry.blogspot.com/

  • BearsRus

    Awesome! I'm sure I'm going to be learning alot from these strategies.

  • Squidman

    I am devoting all of Sunday to studying and solidifying my knowledge of this strategy and you just made it easy for me Fujisan. Your gift is very much appreciated! May I also say that you're hot (in a very cerebral way)!

  • Fujisan

    There is a way to scan high IV and positive skew stocks via option softwares with a various scanning function, but it's not free (and I think Mole has a policy not to have a link to a commercial site, so I won't be able to do that).

    If you like to do this manually, go through earnings calendar at CNBC website and pick the ones that that you know the name, or the ones that come out of the news frequently. The chances are, everybody else is also trading that stcok.

    This IV play works well with biotech companies right before FDA approval.

  • GoCougs

    I was messing with the TOS stock hacker screener and figured out how to search by IV, but what would be an optimum minimum/maximum? Obviously on the front month, you would want no max on IV, but what about back month?

  • Fujisan

    Hey Mole, can I at least pick my own “sketch”?

    I thought that I logged on to a wrong blog site (and I look better than that :->)

  • Fujisan

    You like to have at least 10~20% positive skew between front and back month. I don't know how you can feed that factor into a scan.

  • molecool

    Sure, pick your own sketch next time – I think it'll be hard to top this one but give it your best shot.

  • molecool

    I think finviz.com offers something like that… dig around rats, I'm busy coding…

  • molecool

    Yup, that pretty much sums it up.

  • Fujisan

    A~ha! That was quick.

  • Keirsten

    Forbes use to feature a fabulous screener, but it's gone now. Still digging around for that link and will share if I find it hidden elsewhere.

  • jacksoo

    Anyone having problems with TOS at the moment? Down for maintenance perhaps?

  • Zeusmith

    Fujisan, that's fantastic stuff right there! I'm finally making a concerted effort to learn options after 10 years of exclusively trading equities, and this tutorial is wonderful. I still find calculating the greeks very complicated, and have still a long ways away from actually making an options trade, but this post gets me one step closer.

    Question: Do you find it easier to make money trading options with delta neutral spreads as opposed to just trading stocks?

  • fuzzygreysocks
  • BalaB

    Fujisan!

    Aright……! : )

  • Macrawn

    I love this. Great tutorial Fujisan!

  • Fujisan

    Thanks, Slarty. I already wrote up my next topic – XLF and butterfly variation, but I don't want to overwhelm you guys with so many different option strategies at once, so I am holding on to this for now.

  • Fujisan

    I don't trade stocks as much, so I won't be able to answer your question, but the reason that I don't trade stocks is because you can make money only if it moves. But there are so many different ways of making money with options, both up, down, or sideways (sounds like a informercial….).

    Since you are a stock trader to begin with, I think it would be easier to start with covered call or collar. Have you tried these strategies before?

  • TX_Trader

    Nothing short of Outstanding!

  • matzetina

    Obama ist der Größte! Ich als eingefleischter Deutscher kann sagen, dass er hier 90% (eingefleischte Skeptiker inklusive) VÖLLIG überzeugt hat. Der, meiner Meinung nach, beste Präsident seit Kennedy! Wahnsinn! Wir stehen komplett hinter ihm! Das gab es noch nie! Ich kann nicht mehr, dieser Mensch ist der Wahnsinn, der hat den Nerv Europas komplett getroffen, das ist noch nie (seit Kennedy) dagewesen, passt bloss auf evtll. Attentäter auf, dieser Mensch KANN den Weltfrieden bringen!!!

  • RUFCrazy2

    In suppose I am dense lazy or both.

    I get the IV skew thing – very good observation. . I like number charts better than chart charts for options, so I got little from those TOS charts.

    What makes sense to me to me is to sell front month calls and puts at the same strike (as you suggest for Wed-Fri earnings plays) and to buy the exact same strikes for the next month. I gues that is a calendar spread ?

    Is this what you are saying ?

  • TomOfTheNorth

    I don't suppose this is what you were looking for but you can get the IV of specific issues/strategies:

    http://forbes.optionetics.com/cgi-bin/platinumv

    enter some basic info to get the resulting matrix

  • Keirsten

    YESSSSS! You're good! I tried to use both brain cells to find it, but ahem…. LOL

  • rhae

    Very good Fujisan… We used to call that pinned, when the option did not move and the price did… Yup, my hide has been pinned … Don't play options much, a few cc's..

    Mostly I spend my time with general TA… SPY 10m for trendline lovers.. several anchored lines can point the way .

    .http://screencast.com/t/XsWw9lZAT

  • TomOfTheNorth

    I'm left-handed so I'm in my 'right' brain…..
    (this will also account for my lack of TA skills)

    ________________________________

  • Keirsten

    I'm ambidextrous, which means I can't think with both hands tied behind my back. 😛

  • vad

    How about using a strangle instead of straddle? In case of Rimm, would it make more sense to use 40/55 OTM strnagle instead of 55/55 straddle? If you expect a big move after the earnings, this will make one of your options to react stronger than the other one, no?

  • TomOfTheNorth

    you might want to be more careful giving this bunch ideas like that  ;->

    ________________________________

  • Rhett

    Beware, he models himself on Kennedy, and uses Kennedy's life as a script. Why did he go to Germany?
    Because Kennedy did!

  • pokerden

    Here is a compilation of e-wave counts. Basically three possible counts (Kenny's, GBT +rob46, and Chrys?). With some notes on individual ones.

    http://spyswings.blogspot.com

    I threw Mole into the P2 camp 😛

    Hope I was correct in that one.

  • Rhett

    Just to clarify, your going long the straddle 3-4 days before earnings and then selling it just before earnings? With the expectation the IV will rise into earnings. Otherwise it sounds like to take advantage of the IV crush over earnings you have to be short the straddle. (which in the case of RIMM would have lost big, since it moved so much over earnings).

  • david888
  • Teich50

    The article says “…option pricing is affected by theta (time value), gamma (magnitude of price movement)”. I think the symbol “gamma” should be replaced by “delta”, as gamma is the second derivative of the option value with respect to the underlying [ http://en.wikipedia.org/wiki/Greeks_(finance) ].

    I guess one can trade gamma (by longing it or shorting it) if the portfolio is made delta-neutral first 🙂

  • RUFCrazy2

    That would make sense too Rhett

  • matzetina

    No way, in my opinion, he is authentic, citizen nr. 1, we love him!!

  • TomOfTheNorth

    North Korea has launched a missle over Japan:

    http://news.yahoo.com/s/ap/as_nkorea_missile

    “The multistage rocket hurtled toward the Pacific, reaching Japanese airspace within seven minutes, but no debris appeared to hit its territory, officials in Tokyo said.”

  • Jigsaw

    Interesting how that will effect the markets Sunday night

  • katzo7

    Whitney strike again, found on SoH (armagedon's find)
    http://business.theglobeandmail.com/servlet/sto

  • standard_and_poor

    Thanks Fujisan and Mole, keep doing it.

  • standard_and_poor

    Thanks Katzo.

  • http://trading-to-win.com/ DavidDT

    Great job Fujisan (and good idea to post it Mole)

    From the longer term /es action it worth watching Longer term daily channel for breakout (unlikely soon in my opinion) or strong move down (that would be the one I am betting on right now)

  • mrekim

    You buy the straddle a few days before earnings in order to capture the IV rush right? So you want to buy the straddle before the IV rush occurs.

    Is the 10%-20% positive skew used as a “tell” that the IV may be going up even more into earnings?

  • dust13

    The vast majority of the politicians are corrupt and the more they can take away from the people the more powerful they become. Republicans and Democrats have shown us who they are and the Obamination is in full power grab mode.
    Taxes = steal money from the people
    Welfare = make them dependent on government
    Get rid of religion = eliminate hope and competition. Replace it with enviromenatalism, faith in government. Only they can save us from ourselves
    abortion on demand = devalue human life we are no better than a snail
    government schools = teach and program children their way
    Divide and keep the masses distracted against each other black vs white, women vs men, old vs young, rich vs poor etc
    cashless society = control every move made. Who needs prisons?
    If no one has money, then no one has the time or the means to challenge those in power

    This is not a political blog, so I hope not read anymore garbage.

  • Squidman

    I find it very interesting that WFC keeps sending me correspondence about increasing fees. This has followed them cutting my 15 year old business credit line 2 months ago for no reason. I think the time is coming soon when I will enjoy shorting the hell out of them. And I can't wait to make that deposit, because I will give it to my branch manager specifically. Go Whitney!

  • Fujisan

    It's delta AND gamma. Thanks for correcting it.

  • Fujisan

    Naked means that you are not hedged.

  • Fujisan

    This strategy is to take advantage of volatility spike, and not going for a price movement.

    If your plan is to hold on to your position through the earnings for a big movement, and if you put on OTM strangle, I'm almost positive that you lose 8~9 out of 10 times that you try. The question is, does this 1~2 times win make up for the loss that you might have accumulated?

    You might have made money with OTM strangle in this particular case, but the probability is clearly against you. We are in the probability business and I won't bet my own money on a low probability win.

  • Peasant

    here are some cos reporting this week:
    April 6th: BLUD
    April 7th: AA, BBBY, MOS
    April 8th: EXM, FDO,
    April 9th: CVX, JOSB, MOV, PBY

  • Rhett

    Thnks Fujisan, …interesting play.

  • Fujisan

    Calendar spread for IV play does not work. Calendar is made to take advantage of positive theta, but when IV spikes up, that would inflate the front month options where you are short. In other words, negative vega offsets positive theta and you hardly make money.

  • Fujisan

    Thanks, rhae. I always check your analysis. Very good insights.

  • molecool

    How about selling a straddle the day before earnings and buying it back AFTER earnings have been announced? This way you'd be selling maximum IV and you are only holding them one day – which would add Tuesday to the list of days.

    I must also add that it's crucial to pick high volume stocks with narrow option bid/ask spreads, otherwise your profits might be taken by the MM.

  • molecool

    Ich persoenlich bin von Ihm sehr enttaeuscht – er gibt gute Sprachen aber sein Kabinett ist voll von korrupt Insidern.

  • molecool

    Check out ivolatility.com – that gives you an option's historic IV changes.

  • romeobravo

    Remember, she said to get them 3 to 4 days ahead of earnings and not hold over the weekend which nixes most of these plays. You can't play anything until Wednesday of the say week at the earliest. Also, as Mole pointed out, high volume stocks are essential otherwise any profit you have will just get chewed up in the bid/ask spread on the options.

  • Fujisan

    “it's crucial to pick high volume stocks with narrow option bid/ask spreads, otherwise your profits might be taken by the MMVery good point on high volume stocks”

    Very good point. Yes, this is the key (not just for this particular strategy but any other option strategies in general).

    In regards to selling straddle a day before – yes, it would work very well, probably 70~80% of the time, but there are 20~30% chances that you would lose, and possibly big.

    As options are already highly leveraged, I always try to take a very conservative approach so that one big loss would not wipe out all the previous gains, but I'm pretty sure that you can take a very strategic approach to a naked straddle and be successful.

  • romeobravo

    Fujisan, I am lookng at DNDN as a drug study release play, and I am finding to get delta as close to zero as possible you have to go OTM for the calls and ITM for the puts (May options.) Is delta neutrality the most important thing or being ATM?

  • MrTrader

    EWI says: The U.S. stock market is in a bear market rally. Seven charts across 10 pages make the case.

    http://www.elliottwave.com/single-issues/ff/090

    If anyone here is a member, perhaps you can share details such as: How long will the rally last? How high will prices go? Where do we stand in the wave pattern? What investor psychology indicators will help signal the eventual intermediate-term top?

    oh and a special treat: Jim Cramer Declares The Depression “Over” (VIDEO)
    http://www.huffingtonpost.com/2009/04/04/jim-cr

  • rhae

    Holiday week coming up which can get pushed around do to lite volume… I think a vote coming up Wed on the short up tick rule… rumor or not?

    Most agree a pullback do… But as usual not until it does… Bears can only hope for a trendline bust..
    I think a pull back do, but I have no idea about the route getting to support? And God forbid resistance turns into support.. ( for Bears anyway..)

    http://screencast.com/t/H9M7ENumipZ

  • Fujisan

    I don't know when FDA approval is coming up, but I just saw a huge price spike on Friday. If you are planning to hold on to May options, that may be too far for IV play and you are exposing yourself to a major price movements until then, unless you know how to deal with gamma scalping (gamma scalping is another art of trading that I don't know that many people are able to successfully execute, including myself).

  • Marc45

    I love that video! I hate the message.

    Unfortunately, we are all just pawns. Bend over and smile.

    Time to move to another country…

  • molecool

    Excellent news about Cramer – that pretty much confirms EWI 😉

  • http://www.srsfinance.com SRSFinance

    Moe, thanks for the vid! This is one of the best explanations I've seen. For those who want more on this, check out the Black interview on Bill Moyers: http://www.pbs.org/moyers/journal/04032009/watc

    Markets are really frustrating to me here as they are moving up on what is obviously hot air, yet momo is on the bull's side. Reality will eventually hit and when it does we will see a huge and fast down leg but timing that is a real bitch.

  • romeobravo

    They release a study at the end of April (after OpEx for April.) Yeah, I figured it was not smart to be risked exposed from now until then, but same strategy? Hold 3-4 days before the announcement and get as delta neutral as you can?

  • Paxromanus

    This week's 4best4worst

    Stock Market Cheap?, Shadow Unemployment, Blogger Privacy threatened? More….

    TRUTH….

    Maximus
    http://4best4worst.wordpress.com/

  • Keirsten

    Nothing at all to do with the markets, but worth being aware of, and definitely worth an email to your reps to complain IMO. They just keep chipping away at our Constitution.

    “The Cybersecurity Act of 2009 (PDF) gives the president the ability to “declare a cybersecurity emergency” and shut down or limit Internet traffic in any “critical” information network “in the interest of national security.”

    The bill does not define a critical information network or a cybersecurity emergency. That definition would be left to the president.”

    http://www.motherjones.com/politics/2009/04/sho

  • Peasant

    Fujisan, do you ever employ this strategy when IV is not as high? what are your thoughts on this possible trade?

    CVX reports this Thursday, April 9th. CVX closed at 70.48 on Friday. The apr 70 call and put has the highest open interest so the market is expecting this stock to not move much from it's current price. The IV on CVX's 70 strike is pretty low though according to my quote source.

    The apr 70 call and put closed on Friday with a bid of $2.25 and $1.75 respectively.

    Sell the Apr 70 call for $2.25 and sell the Apr 70 put for $1.75 for a net credit of $4.00/contract. Given that the market expects the stock to remain relatively close to 70, would you consider holding it until expiration? TIA.

  • Peasant

    Bingo. I like the idea of moving to the British Virgin Islands: http://en.wikipedia.org/wiki/Taxation_in_the_Br

    As a U.S. citizen, would I still be subject to current U.S. capital gains tax and future increases to that if I moved abroad? in addition to trading taxes planned by Obama?

  • Peasant

    I have 2nd and 3rd cousins that are German and live in Germany and Austria. They always complained about Bush and his cowboy ways during his tenure. Yes, he sucked as a President but the Republicans aren't the only ones to blame. Both sides are corrupt and incompetent.

    GWB began his Presidency at the Peak of the U.S. economy and if you believe in Robert Elliott's supercycles, there was little he could do to stop the demise of the U.S. economy. The Iraq war is a different story but European's perpetual passivity is not the answer either.

  • Fujisan

    This strategy is called “naked straddle”. Naked straddle has a huge margin requirement (basically you are committing yourself to an unlimited downside in order to collect ATM premium) and risk/reward ratio is not that great. Particularly in this case, IV is not high enough to risk for an unlimited downside.

    If you like to limit your downside and yet benefit from ATM premium, go for ATM butterfly instead of a naked straddle. This way, your downside risk is limtied to the premium that you pay. But is it really worth your premium to put it on before earnings?

    Personally, you can find this type of trade anywhere, anytime, and there is nothing special about it to initiate the trade at this particular moment. If you like to do a delta-neutral, positive theta trade, wait until earnings, or even next month. You can find relatively stable stocks going through a range bound where you can put ATM butterfly on to earn time premium.

  • http://www.aggressivelyuninformed.com nepharis

    Thanks, Fujisan, this is awesome. I've been skeptical of the complex spreads for a while, but between this and the POP chapter on options, I'm reconsidering. Spending a lot of time with TOS's spread simulator — this thing is awesome.

    Cheers!

  • wex

    as a US citizen you are liable for taxes on all your income no matter where you are located.

  • TomOfTheNorth

    Cramer has been a raging bull for a week now – absolutely giddy.

  • MrTrader
  • salvadorveiga

    We actually said, the DEPRESSIOn IS OVER. the achor asking him “will we see lower prices?” “NO WE WONT” …

    Didn't this guy learn a thing from the Jon Stewart thing ? Damn what a jackass… and then he gets surprised if people rant about him…

  • http://spnakr007.blogspot.com/ Steve

    haha, this is great…Love IT!!!

  • vdub

    Here is another way to make money on earnings. This works best for high flying stocks where earnings are the week after expiration. You make the IV rise work in your favor. AAPL is a good example.

    For example, IV for AAPL starts to rise about 3-4 weeks before earnings. IV can often rise 5-15 pts.

    The Trade: Enter a double calendar on AAPL starting about 3-4 weeks before earnings. Go Short the front month and Long the earnings month. The IV rise will hold up the back month even in tough markets because of the IV rise in anticipation of earnings. The double calendar gives the underlying a little room to move around in price without killing the position unless it makes a really big move. Depending on the IV movement in the back month and barring any really big move in price, you can make 10-30% in a couple weeks.

  • molecool

    WEEKEND FORECAST IS UP – GET IT WHILE IT'S HOT!

  • katzo7

    Thanks S&P.

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  • segaa

    Bartholomy wrote>Annonced grow of 3.4% is unexistant, it have been mathmetically tweak to get so…

    I would say that we lived with “mathematically tweaked growth” already god knows how many years and everybody was happy about that. LOL

  • segaa

    Bartholomy wrote>Annonced grow of 3.4% is unexistant, it have been mathmetically tweak to get so…

    I would say that we lived with “mathematically tweaked growth” already god knows how many years and everybody was happy about that. LOL

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