Dan Sheridan explains why the Double Calendar may be a good play based on past GOOG trends - Part Two.
Previously I discussed two ways to capitalize on an earnings announcement. The most common method is to wager on a big move after earnings are announced. Examples of such plays include the Long Straddle or Long Strangle.
Another way is to take advantage of neutral, range-bound behavior as an earnings announcement approaches. Though there may be a major price swing in either direction after earnings, some stocks tend to remain stagnant in the weeks before the earnings date. This was the rationale behind the trade idea for a Double Calendar Spread on Google.
Below you will find the trade set-up. After that I will respond to some real-world questions on this strategy.
THE PLAY: DOUBLE CALENDAR SPREAD
PLACING THE TRADE
Here is a potential Double Calendar play based on historical prices from September 4, 2008:
Stock at entry: GOOG near $458
Day to enter: between September 18th and 25th
GOOG earnings date: October 16th (unconfirmed)
Sell to Open Front-month Put at Strike A: 1 GOOG October 430 Put at $15.50
Sell to Open Front-month Call at Strike B: 1 GOOG October 490 Call at $15.10
Buy to Open Back-month Put at Strike A: 1 GOOG December 430 Put for $25.40
Buy to Open Back-month Call at Strike B: 1 GOOG December 490 Call for $26.60
Total Cost for Double Calendar spread entry: $21.40 net debit (in other words you will pay out $2,140 at the beginning to run this play with one contract)
TARGETS AND EXIT POINTS
Maximum gain: $19.60*
Maximum loss: $21.40 net debit
Break-even points at expiration: $407.08* and $530.79*
Profit target exit: when spread value is between $23.50* and $24.60*
Stop loss exit: when stock hits either one of the break-even points*
Time stop exit: October 9 (one week before GOOG's earnings announcement)
*For the purpose of this example, all data is from September 4th. These numbers are approximate and don't constitute a forecast. Actual figures will vary depending on movements in the market.
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ALL-STAR COMMENTARY
Now granted, this stagnant strategy is intended for quiet times. The market has been anything but calm over the last few weeks. However I still wanted to address some well though out questions from Old Fart. I hope the following answers will better prepare you for when the market decides to settle down. It's always a good idea to have multiple tools in your trading arsenal. Old Fart's quotes are in italics. The stock chart and previous Profit and Loss graph are above.
I am using a similar very short term strategy to participate in earnings releases. One example might be an after-hour earnings release and in this case I would place the Double Calendar in the final hour before closing. Yes, large moves after the release are not good but IV of the front month options will crash down and the Double Calendar is short these options.
Yes, Implied Volatility crashing down is very important, but the price movement of the stock is key. The real question at hand is whether you think the stock movement caused by the earnings release will exceed the breakeven points of the Double Calendar spread. Double Calendars are a good vehicle to use around earnings when you don't expect the price movement to be greater than the average move of the last three to four earnings announcements. As for GOOG, it usually gaps 6-7% on earnings, so if you hold this strategy as you explain, the movement of the stock may wreak havoc on the position. Even if you are collecting time decay and capitalizing on declining volatility, the movement of the stock may cause losses that are in excess of any gains from the other two characteristics.
I have developed some tools to size the expected move. One such tool is the option prices themselves, the price of the ATM straddle. If the market makers are willing to be short at these prices, there is a good probability that the move will be contained within the price of the straddle.
Market makers price in the expected movement within the price of the at-the-money straddle. So if GOOG is at $500, the 500 straddle in the earnings month will be around 6-7% or $30-$35. But if I (market-maker) sell the straddle to a customer at $30, I might buy the 520 calls and 480 puts to hedge my price risk. Market makers are not selling naked straddles without getting protection. They don't know how the stock will react to the earnings report. Atypical things can happen, like on April 18, 2008. Google gapped 20% (approximately $80-$85). Market makers are simply pricing the straddle based on the past three to four earnings and what they think will happen for the current earnings announcement. However, they will always buy "wings" (out-of-the-money calls and puts) in case they are wrong.
I have a few questions regarding the GOOG Double Calendar you discussed in the original post:
1. What is your approach to determine the width of the Double Calendar - one Standard Deviation at open time, price of ATM straddle, something else?
I base the width of the Double Calendar on the average earnings move of the past 3 earnings. GOOG usually moves 6-7%, so I like my strikes around 6% out-of-the-money. I use Standard Deviation all the time for my normal income trades like condors, but for earnings, I look more at the past price movement around earnings and the current ATM straddle to come up with my expectation of a future price move.
2. You mentioned that IV will rise and in general this is good for the position. If we look below the surface the most IV rise will occur in the front month options and the Double Calendar is short these. I agree small IV changes affect longer-term options the most, is this what you had in mind? In this case should we use the second month for the long options? The second month is always available and it will be used by everybody for hedging thus bringing the IV up
You are correct; the Implied Volatility in the near month will rise more than the next month out (your long option in a Double Calendar). This won't hurt as much as you think because of the much bigger vega of the long option, especially as you get closer to expiration. The key that makes this Double Calendar work BEFORE earnings is the stock stays between your breakeven points for a couple weeks during this semi-quiet period, and may allow you to take out 15%-20% profit. Gains from theta will usually offset any loss resulting from increasing implied volatility of the short options.
At the time this blog was posted, the option months available were September, October and December. With earnings on October 16th, the only two months to be used were October and December. After September expiration passed, November options became available. It was only after this occurred that the two month Double Calendar could be traded.
3. What is your approach if the short strikes are hit before the profitability goal is reached - close the position, purchase the next calendar up/down to bring the position close to delta neutral or something else?
If the break-even points are hit prior to earnings (not the short strikes) one choice is to close out the Double Calendar Spread. Another alternative is to adjust part of the trade to get strikes out-of-the-money on both sides. For example: if GOOG is at $500 we might do the 530 and 470 calendar 6 times. The break-even points might be 465 and 535. If GOOG hits the upper break-even point of 535, I might close three spreads of the 470 calendar and then buy three 535 calendars or three 540 calendars.
Thanks again for the questions Old Fart. I hope this Q&A has helped people get a better understanding of this set-up and how to implement it.
Owner and Mentor
Dan's previous posts: Getting Familiar with Earnings Plays and Top Five Reasons to Trade FROs
Click here for a list of previous TradeKing All-Star blogs.
Nicole Wachs contributed to this post.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
The theoretical returns mentioned are not actual and do not guarantee future results.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
While Vega represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (point) change the implied volatility the option contract there is no guarantee that this forecast will be correct.
While Theta represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract there is no guarantee that this forecast will be correct.
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Dan Sheridan has a professional business relationship with TradeKing.
