One of the options strategies Jeffery Augen discusses in his excellent book, “The Volatility Edge in Options Trading” takes advantage of the typical ramp up in option’s implied volatility (IV) before an earnings announcements. Upcoming announcements create uncertainty, and the option market prices that in by increasing the premiums—which is reflected in the IV of the options. This ramp up in IV can be surprisingly high. The chart below from Schwab’s StreetSmart Edge®, shows a two year history of AMZN with the average IV of its call options shown below.
You can see how average IVs in the high twenties have ramped up into the 150s right before Amazon’s earnings announcements.In order to take advantage of this, Augen suggests a long strangle position, created a few days before the IV ramp really gets going. Normally I hate being long options because of the time decay factor (theta), but in this case the IV ramp up at least partially offsets these losses. Ideally the options used should expire quickly after the earnings announcement—the CBOE’s WEEKLYSSM options are well suited for this strategy.
In this case Amazon’s earnings announcement was scheduled for January 29, 2013 so the weekly options expiring on February 1st were a great fit. These options started trading Thursday the 24th.
Thursday the 24th, Amazon was trading around 275 and the weekly options opened up trading with IVs in the high 50s. I bought S285 calls and S265 puts to bracket the trading price with a 3.5% offset for a net cost of 11.5. The delta on these options was +-30 at the time (a 1 point move in AMZN should move their price by .3), so at inception the trade was delta neutral.
Some sort of directional movement before the earnings announcement is needed to make this strategy profitable. If the stock stays right around the centerpoint (275 in this case) the rise in IV will probably not be enough to offset the carry costs, however if the stock moves a few percent either way the combination of rising IV and premium as it approaches a strike price should generate a good profit.
On Friday the 25th Amazon made a 3% move up to 283. I held on over the weekend hoping the upswing would continue, but the stock started to retrace so I sold out at 15.0—for a 30% profit.
First posted: Thursday, January 24th, 2013 | Vance Harwood