Earnings season provides numerous opportunities to develop options trading strategies that are intriguing in high implied volatility trading situations. Stock indices experienced that during the Brexit vote and many individual stocks are experiencing that now. The choice of options trading strategies is limited, but the number of scenarios in stocks, ETFs and futures is limitless. This week’s earning announcements in Amazon, Apple, Facebook and Google provide an opportunity for those that are interested in purchasing the stocks at lower levels to design a position that enables them to earn income and potentially buy the stock at a lower level.
Inflated implied versus historical volatility typically exists when there is an anticipated news event. In the case of Brexit, this divergence of implied and historical volatility was prevalent in currency options but, surprisingly, not in stock index futures. This created an enormous trading opportunity if you realized the potential of the stock market’s movement after the Brexit vote.
The same scenario currently exists in the disparity of inflated options prices in certain individual stocks as compared to historical volatility and contracts like the E-mini S&P whose implied volatility, due to the rally, is significantly below its 20-day historical volatility. The recent rally in stocks to new highs has provided for low implied volatility in stock indices and, because of expected earnings announcements, high implied volatility in a multitude of individual stocks.
These differences enable traders with a significant amount of risk capital to establish interesting implied volatility positions which can meet their directional or volatility needs. In the case of Amazon, Apple, Facebook and Google, all with earnings announcements this week, there is significantly inflated implied volatility compared to historical volatility and for good reason. Earnings announcements will likely move the stock prices significantly. The question is what options trading strategies can we use to provide a methodology to produce some income and potentially an opportunity to get long the stock at lower levels? Our Options Webinar Preview PDF provides a detailed look at some of these strategies.
The strategy I’d like to focus on is the 1X2 Put Spread which provides some income and in a worst case scenario provides the opportunity to get long a stock that you want, at lower prices. For traders who execute the strategy it is important to realize that it is an unlimited risk strategy and the amount of money generated is miniscule compared to the cost of the stock you would be required to take delivery. That said, if you wouldn’t mind taking the delivery of the stock at lower levels it’s an opportunity to take advantage of elevated implied volatility and the implied volatility skew.
The example below is for a 1x2 Put Spread in Amazon taken during trading on Monday. I’ve chosen the August expiration however; you can structure the trade to meet any of your timing needs. You can pick different Strike Prices or expirations, all of these parameter will provide you with appreciably different opportunities and amounts of risk. In the Amazon example shown, you buy one 700 Put and sell two 675 Puts for a credit of 1.75 or $175 per 1x2 Put Spread. If earnings are not what was expected and Amazon tanks, you’ll be required to ultimately take delivery of the stock at $648.25 which is a little less than $100 from its current price. If the stock rallies, you’ll collect the premium. If the stock deteriorates there is always the chance to make significantly more money at levels near or between the Strike Prices. If you have any questions about this strategy, or want to learn more about options trading, Contact Us.
Although the Implied Volatility Skew in this particular example is not as great as I would normally look for, the 1X2 Put Strategy provides traders with the opportunity to establish a mildly long position with a number of factors in their favor. Earnings season can be particularly volatile, but that volatility creates a wealth of trading opportunities for those with significant risk capital. It is essential to evaluate the liquidity of the options you are trading, make a comparison of the implied and historical volatility and understand the risk/reward scenarios of your trade.
Options trading involves significant risk and is not suitable for every investor. The information is obtained from sources believed to be reliable, but is in no way guaranteed. Past results are not indicative of future results.