Dual OTM Fly's for Earnings

Discussion in 'Options' started by erol, Feb 10, 2010.

  1. erol


    So I'm trying to think of ways to profit from declining IV pre earnings.

    If I'm short a straddle, then the problem is IV will drop, but the underlying will move.

    Short Calendars solve the problem, but I'm long the front month, which is (-vega), so I may not get the profit I'm forecasting.

    What I was thinking, is two OTM butterflies.

    One OTM Call Fly

    One OTM Put Fly

    So for example, take FSLR, which has a high IV, whose earnings are due fairly soon.

    Spot is $109.60

    I'm thinking:
    Long FEB10 70/90/110 Put Fly
    Long FEB10 110/130/150 Call Fly

    Aside from high commissions and slippage, is this a bad strategy?

    I guess the risk is, if the underlying doesn't move post earnings, and IV drops.
  2. MTE


    It's not a bad strategy aside from commissions and slippage. :)
  3. Your profit curve looks like a big letter M with the max loss at stock below 70, at 110, and above 150. The max profit points are at 90 and 130. Your breakevens are right in the middle of those.

    That's a lot of legs; 12 commissions if you unwind before expiry. 12 places slippage can nickel and dime you..

    I would paper trade these for a while and see how you like them.
  4. spindr0


    As SomeYoungGuy pointed out, the risk profile is M shaped with max loss at 110, peak profit at 90/130 and breakevens at approximately 80/100 and 120/140.

    You have 6 legs going in and if lucky, 2-2 commissions to close (the other butterfly will expire worthless). The commissions and slippage are going to kill you ... but it's not a bad strategy if you trade at 90 or 130 :)

    I don't like M shaped risk curves where there's a wide range of initial loss (b/t 100 to 120) and it's fairly deep (nearly $1,000 at 110).

    The EA is tentatively next Thursday so it's hard to know today what will "fly" next week. IV's are likely to bump up some more.

    I would look at a ratioed calendar straddle or strangle (U or W shaped) where a smaller move will get you into the profit zone. Far fewer legs to deal with and its intent is to capitalize on the disparate month to month IV levels and post EA contractions (Feb will get hit far harder than Mar).

    Since the EA is the day before expiration, I'd take a look at a double ratioed reverse calendar strangle/straddle if March IV is particularly elevated. Reverses are much more desireable near expiration since the throwaway Feb premium is much lower but an EA Thursday PM isn't for the faint of heart since it's make or break on the last day. 2-3 days gives you a little buffer for a secondary move and further 2nd month contraction.

    These are always commission/slippage intensive (but better than a double fly) and only make sense if you spot a good month to month IV relationship (skew) with elevated IV. They tke a bit of work to find and you often need to work the entry to get a decent fill (leg in via component straddles, strangles or calendars).

    This probably makes little to no sense but what else is new on ET ??? :)
  5. spindr0


    EDIT: You have 6 legs going in and if lucky, 2-3 commissions to close (the other butterfly will expire worthless).
  6. erol


    wow, awesome spin, thank you.

    I'm trying to think of ways to make money on earnings, but I haven't figured it out yet.

    Anyways, I'll look into these, really appreciate it.
  7. spindr0


    Here's a generic description of the process.

    Identify EA stocks with increased overall IV. Check option chains for horizontal skew in front 2 months ( > 15 BPs). If you find a few, check graph in IVolatility to see what historic level is and how much they imploded post EA in the past.

    Input data into option model where you can select post EA IV guesstimate to see how the strategy performs one day later (not expiration). As a general rule, you don't want to hang around hoping for a better result. It is what it is the next AM.

    What the ratio is and what strikes are used is a trial and error process since there are multiple variables (time to expiration, skew and amount of IV collapse ). The idea is to tweak the number of options and the strikes used in order to get a risk graph that's acceptable. The premiums determine that. You can tilt the bias up, down or balance it. Balanced means that you have no clue which direction it's going :) You can also use what I call kickers (buy a cheap OTM strike to shift bias or manage extreme movement risk).

    Use all combo order combinations to leg in. For example, a calendar strangle is also a pair of OTM calendars or a pair of diagonals. It's not unusual to get a 10-20 cts better fill with one (use price alerts) and yet either way gets you to the same final position. 20 cts on both sides can make a big difference in the attractiveness of a risk graph.

    Keep in mind that you can and should use stock the pre/post market to defend your position. An example of this would be your aforementioned double butterfly. Suppose after the EA, FSLR exceeds a max profit point, say less than 90. If it continues down past 90, you're giving up profit. If it gets below 80, you incur losses. Know your delta and short some stock if necessary. Make sure to be watching the stock during and after the conference call since it can set things off again.

    I prefer AM releases since overnight can bring surprises but a majority of the good ones are PM releases.

    Getting out the next morning is an art in and of itself. Closing everything at market prices is convenient and safe. But if you have a handle on discipline and risk tolerance, you can leg out. This is not for noobs or deer in the headlight types. IV often drops "X" initially and then "Y" throughout the morning. You might consider closing some of the long leg(s) ASAP for less loss (more gain) while IV is higher and scaling out short legs as IV continues to drop (for more gain/less loss).

    Adjustments is a whole nuther story. For ex, you can mutate a diagonal into a butterfly or a diagonalized butterfly. I'll leave that one alone :)

    Finding these critters is time intensive but the end result is higher probability trades.
  8. erol


    thanks again spin... this is really helpful, and I think if I tried to look for all this stuff in books or videos it would have taken me a long time. So this is awesome I appreciate it.

    I'm gonna save this and go through it, make sense of it, "simulate it" and see what you mean exactly!