Calendars and butterflies are our only two basic options. Calendars require a view on forward com. Butterflies require a view on the distribution. In both cases you are making the bet that the short option is more rich than the long option.
I'm not sure that is always correct... That is a rather absolute statement.. shorting straddles takes alot of margin.. which creates a position size/liquidity risk for the trader.. Defining risk has a certain value in itself.. You might disagree.. but that's cool to.. To assume in every case that tail risk is so overpaid for in otm premium is to general.
The extreme contraction in the smile is enough to dissuade me. I literally got my bells rung going naked for a time. It's one of those things I try not to regress to like selling biotech options. Even the word Pharmaceutical scares me because the lines between industries are getting grayer.
Yes straddle margin is definitely the other issue. The fly is probably the best choice given you can lock in your max loss on entry, makes it easier to manage the position. Interesting thesis paper here, ties in with what i previously mentioned around earnings straddle mispricing in lesser known firms. Its pretty old though. From the abstract : Furthermore, we find the positive straddle returns are more pronounced for smaller firms, firms with less analyst coverage, higher past jump frequency, higher kurtosis and more volatile past earnings surprises. This finding suggests that when the firm’s information environment is less transparent, or when there is more noise in the firm’s signals, investors are more likely to underestimate the uncertainty around earnings announcement days. Any other thoughts on this strategy? I might try it out for few weeks but with small sizing.
Selling, or buying, vol into earnings reports is a binary bet. Many people do it because they like to gamble. Sure, there is plenty of research out there, but the fact is that all available information is incorporated into market prices. Most studies that I have seen that show a favorable return require that trading thousands of earnings releases over many years, which is not realistic for most. I highly doubt that there are many "consistently mispriced" straddles for a given firm. If the pricing was so consistently wrong, MMers and other participants would have normalized it. I do not know what lesser-known firms you have looked at, but take into account the width of those markets if you intend to trade them. Regarding trade selection, flies will always limit your risk, but if you are wrong you'll still lose a large amount of the debit. A atm long calendar would not be advisable in these situations. Vol will almost always tank after the the news, which will really hurt the back month option. If there is a sharp price move, the short gamma of the fronts can overtake any gains from the IV drop. It is possible to make a winning earnings bet. But, keep in mind, successful option trading is about generating consistent PnL, an most notably about avoiding catastrophic trades. Unless, you bet the farm on one trade, and retire.
There's another strategy, long gamma but short volatility, staring me at the face. It's too obvious and I must be missing something. No, it's not a Feldman 9-iron Butterfly or a Hawkins Ladder.
My experience has been that this obstacle overwhelms all other considerations when looking at vol plays in illiquids. Even with a lot of attention paid to execution, harvesting the edge in these situations is largely impractical.