Newb Q on Selling strangles into earnings to profit from IV dump

Discussion in 'Options' started by gangof4, Apr 27, 2006.

  1. gangof4


    Looking for opinions on whether the current post earnings IV dump is unusual, and whether my analysis is flawed.

    I've done ok with buying mostly strangles into earnings. lately though, the dump seems much more pronounced- across the board. seems the iv before is higher than usual and the next day dump more severe. i'm seeing so many positions where you get a good % move in the underlying and end up down 80% on one end and ALSO down 25% on the other.

    Look @ something like ISRG tonight: if the move holds, it's up $15/15% after hours and it may STILL be profitable (or a minimal loss) if you wrote the May 105 straddle for $16.50. geesh.

    In my watch universe, and even looking @ the big % movers list, writing a straddle or strangle is batting like .900- many times taking gains on both the calls and puts.

    sure, with the risk of a rocket, the strategy isn't bulletproof, but it sure seems to me that, as long as you're spreading the risk around, the gains from the overnight IV dump on the majority of positions will more than offset the occasional gap up/down.

    am i missing something, or is this a damn good strategy over the long term?

  2. Maverick74


    You are missing a lot. LOL. You don't appear to have an understanding of probability.
  3. gangof4


    when you're done laughing out loud (if only i were so easily amused), care to elaborate? the person who is on the wrong side of probability is the buyer. what % of long strangles with 70%+ IV's purchased the day b4 earnings are profitable the next day?

    i didn't want to make the question so long as to not be read- so i didn't go into the obvious details. ie: use the strategy when the position is priced so dearly that, based on historical vol and historical earnings vol, the strangle is priced for the 100 year flood. ISRG was an example to show that even high vol stocks needed monster moves to work out on the long side. most of the positions i have been noticing are in stocks that were priced so as to require a >20% move to break even, when the stock has no history of such a move and the technical set up made it even more unlikely.

    so, please explain why i am so embarrassingly wrong so as to elicit mocking laughter...
  4. Maverick74


    Forgive my laughter please, it's probably just carryover from chit chat. LOL. I'm still laughing, jeez.

    OK, let me try to explain. Do you have health insurance? Car insurance? Any form of insurance? Well, if you do, you would know that insurance rates have gone ballistic the last few years. For all practical purposes, you are probably grossly over paying on all your insurance. In other words, you are a long premium holder getting a bad deal. Or so it would seem.

    The insurance companies, the premium sellers, are raking it in selling you this premium, or so it would seem. What you don't see are the substantial increase in medical claims the last couple of years, or the large outlier events if you will.

    They are there, trust me. Most people don't see them because we are not looking for them. Everyday there are catastrophic moves in stocks, just about every day. Moves large enough, that if you sold enough size in naked straddles, you would be out of business. But chances are, if CNBC doesn't mention it, or if you don't have money on it, it will pass you by. In your mind, it doesn't exist. The proverbial if a tree falls in the forest and nobody hears it, did it really fall?

    Where I am going with this? If you sell enough of these, you will hit a pothole, a big pothole. The profits you earn on these will be tiny, but they will occur often. The losses will be catastrophic.

    Look at how many insurance companies go out of business every year, especially during hurricane season. This is despite the fact they are raping their customers with serious over charges. The bottom line is, you can't sell enough premium at high enough prices to cover the debacles. The reason for this has been explain ad infinitum by Nassim Taleb. That is, all large unexpected price moves are seriously underpriced. Sometimes to the magnitude of 50 to 100 times. It's almost embarrassing how underpriced the options are. Even when the implieds are trading at ridiculously high levels.

    The irony is, by spreading out and doing a lot of these, you are actually increasing the probability of blowing out. Think about like this. Say you were going to have unprotected sex with another woman (assuming you are a male). Let's say there are 10k women to choose from in a certain subset. Let's say 100 of them has AIDS. Your best bet is to pick the hottest chic and have a go at it. Assuming there are no other men entered into the equation where we then enter a game theory situation where the most men will choose the hottest women (John Nash wrote a paper on this). If it's only you and you know 100 of these women have AIDS, you certainly do not want to sleep with all of them! In fact, the greedier you get by sleeping with more and more women, the higher the probability you have of contracting AIDS. Your optimal situation would be to select one. Every additional one you select, is not spreading your risk around, but increasing it.

    So no matter what you do, as long as you sell naked straddles, you are exposing yourself to catastrophe. It does not matter the duration in which you hold the short straddle. And it does not matter if you do 1,000 of them, sooner or later, your Katrina will come, the hurricane, not the attractive girl. LOL.

    There are a million ways to make money trading that do not carry the disaster tag with it. It's the same reason young people opt to go to medical school or law school instead of becoming a drug dealer even though it pays the same and in some cases more. No one wants the extra risk if they can avoid it.
  5. gangof4



    first, thanks for the reply.

    appreciate the analogies- that is much the way i have tended to look @ writing naked options. the earnings strangle write idea is something i've wondered for a couple of quarters. this quarter, finding too many strangle buys too expensive, i started tracking how each would do if i wrote it, while also looking @ each days % winner/loser lists to calculate the worst case scenarios. my surprise has been that the worst cases haven't been all that bad- especially when ferreting out the positions i would have never entered (ie: sitting @ key resist or support). certainly not a sample to hang your hat on, but it's more than a couple hundred this quarter. a key is certainly to enter late in the day, and exit relatively early the next day. not sure how, or if, there's a legit way to back test- or what program i'd use to do so.

    not sure if i completely buy into the insurance analogy being accurate. reason being, if you're writing strangles on stocks like BA, or even AKAM @ current prices, you're not going to see a 30% move overnight based on earnings- muchless a Katrina sized move. still, obviously not a strategy you'd consider circa 1997-2000 in tech or the past couple years in commodity/old economy names.

    the bigger risk would seem to be having bad luck to put the trade on and then have a news event crater the whole market overnight. not well versed enough on more complex strategies to know how i could mitigate the risk to avoid a knockout blow without trading off the upside. another reason why it's time to learn beyond winging it on novice level understanding of pricing and strategies.

    btw, this foray into options trading has been humbling after 20+ years of making a living investing (ie: not trading) in equities. so much to learn. finally realized that my stock picking and technical skills are not going cut it alone or make up for a lack of TRUE understanding of options pricing, complex strategies and concepts. so, yeah, just ordered McMillan's book to start. strange to be such a newb again...
  6. Just speculating here but if you have been influenced by Riskarb's combo to fly conversion journal then I can understand where you got this idea from.

    I don't think it was originally the intention of the journal creator to apply the strategy in an earnings environment but that seems to be how it is now being used judging by the latest entries. Each to his own! I'm certainly not criticizing - I play along sometimes too but try to avoid the earnings set-ups and being totally naked options in general.

    I would largely agree with Maverick on this one LOL. There are clearly reasons why IV gets inflated and you will never know if/when that IV inflation gets translated into movement until after the fact.

    Recommended books have been covered many times before but in addition to McMillan, suggest you have a look at Option Volatility & Pricing by Natenburg and also Dynamic Hedging by Taleb.

    Good luck!


  7. BA and AKAM don't have to move 30% for combo's seller to have a catastrophe. Watch the action on MSFT 27.5 straddle today. Who ever sold this "inflated " IV combo , will need to spend three times more money to buy it back. And stock moved only 8% , far away from Katrina analogy.
  8. correction , make the loss on MSFT four to five times now (down almost 11%), unreal
  9. Pabst


    One of your best posts ever. I would add the following caveat, one need not be fatally "loaded up" on any single naked short premium position. One could undertrade a portfolio of seemingly rich IV's. Thus instead of getting full blown AIDS you could perhaps limit your hit to just genital herpes. :D
  10. Pabst


    I wonder how many folks saw the huge OI on both puts and calls at the May 27.5 strike and thought the stock would be "pegged" at that level through expiration. Of course three weeks from now, who knows.......
    #10     Apr 28, 2006