Earnings Day Option Strategies – Implied Volatility Play – Part I

Due to uncertainty surrounding the movement of stocks on earnings report day, there is usually high demand from speculators for put options (for those having bearish assumption) and call options (for those having bullish outlook). Due to this temporary high demand piled on by the speculator, we see a jump in the implied volatility (IV) of the options and which in-turn gets incorporated into the pricing of options & make them expensive than usual.

Best analogy for implied volatility (uncertainty/risk) is insurance. If a person is at a high risk of disease, the health insurance premium for them is high. Similarly, stocks with high uncertainty will demand high premium.

This phenomena of high implied volatility in stock options has been observed across several stocks going into the earnings report day making the premium to buy options expensive. Implied volatility in stock options is a mean-reverting entity which reverts to the mean once the uncertainty (earnings report) surrounding the stock goes down. It has been observed that Implied volatility of options drops sharply immediately after the earnings results are announced and consequently the premium of the options also drops sharply.

So, how can one take advantage of this information on spike and drop in IVs and premiums of options around earnings days?.

We take advantage of this opportunity by selling expensive premium (by writing/shorting options) before the earnings results are announced and cover the options right after the results when the IVs drop sharply.

Today, the May 16th 2017, are the earnings results day of PNB, ANDHRABANK & TATASTEEL which are part of NSE FNO. We will take a look at what options strategies one can employ on these stock options and what is probability of profit and the risks lurking around.

First, let’s begin by checking whether the IVs have spiked in these stocks by looking at their IV Rank (IVR)  & IV Percentile (IVP) .

IVR and IVP will rank the current IV of the stock over the IV of past 6 months. Higher ranking means higher IVs and expensive premiums.

I usually consider IVP for my option strategies and my experience has been that IVP of 90 and above are better for our options strategies. Some people also use IVR of 50 and above for their strategies. Please stick to IVR or IVP and not both for any of your strategies, don’t try to curve fit.

This is the IVR & IVP table for NSE stocks  with IVP>90 as of 15th May, 2017

 

IV Rank & IV Percentile of Stocks on 15th May

As you can see, PNB and ANDHRABANK are the among the top IVP candidates and therefore we can examine these stocks to see whether we can use them in our option strategy. TATASTEEL has an IVP of 85 and therefore is discarded from this study.

You can track Intra-Day implied volatility of Stocks on their Earnings report day here.

PNB

PNB has an IVP of 98.33 which means the 6 month historical IV of the stock has been below the current IV 98.33% of days. So this is good as it makes the options expensive.

Two widely used non-directional strategies on earnings day are Straddle and Strangle option strategies. I’m not going deep into what straddles & strangles are, you can read about them here

Straddle of PNB

In Straddle option strategy, we sell one each at-the-money (ATM) strike call option and put option.

At current time, PNB spot price is quoting at 165.5 and nearest ATM option strike is 165. So, we sell one 165 put option and one 165 call option.

1 PNB 165 call option  premium = 6.15 (call price) X 3500 (lotsize) = 21,525

1 PNB 165 put option  premium = 4.95 (call price) X 3500 (lotsize) = 17,325

Total Premium = 21,525 + 17,325 = 38,850

38,850 is the total premium obtained by selling the PNB straddle and it is the maximum profit obtainable from this strategy and it will happen when the stock price at expiry is 165.

This strategy will start losing money if the stock moves & expires below 154 or above 176 giving a protection of -6.95% move on the downside and +6.4% move on the upside. This is the risk one should acutely be aware of. There have been numerous instances where stocks have moved by more than 10% on earnings report day (ICICI Bank one being recently). If you are ready to take such a risk, then this strategy is for you.

The aim of options strategies on earnings report day is to strictly square-off the positions once the results come out as the IVs of the options revert to mean thus making the options cheaper.

Here is the pay-off of Straddle of PNB

Pay-off for PNB Straddle

 

Update on PNB Straddle Strategy post the Earnings Day Report

In order to calculate the Profit/Loss (P&L) of the Straddle strategy of PNB, we need to calculate the option premium left on the original positions. So, we check the premium of 165 call & put options which we have shorted (hypothetically) before the result.

1 PNB 165 call option  premium = 1.65 (call price) X 3500 (lotsize) = 5,775

1 PNB 165 put option  premium = 10.25 (call price) X 3500 (lotsize) = 35,875

Total Premium = 5,775 + 35,875 = 41,650

Profit/loss = 38,850 (Original Premium) – 41,650 (Premium post-result) = -2800

So, we incurred a loss of Rs 2800 on this strategy mainly because the stock moved strongly and came close to breaching the upside protection of 176.1. Theoretically, you are still not in loss if the same position holds till expiry but since we want to square-off immediate post the results it is wise to take the loss and move on.

Strangle of PNB

In Strangle option strategy, we sell one each out-of-the-money (OTM) strike call option and put option. The choice of strike usually is one standard deviation (1SD) move from the current stock price.

At current time, PNB spot price is quoting at 169.2. So, we sell one  1SD move 155 strike put option and one 1SD move 185 strike call option.

1 PNB 185 call option  premium = 1.45(call price) X 3500 (lotsize) = 5075

1 PNB 155 put option  premium = 1.2 (call price) X 3500 (lotsize) = 4200

Total Premium = 5075+ 4200= 9275

9275  is the total premium obtained by selling the PNB strangle and it is the maximum profit obtainable from this strategy and it will happen when the stock price at expiry is between 155 & 185.

This strategy will start losing money if the stock moves & expires below 152.4 or above 187.6 giving a protection of -9.93% move on the downside and +10.87% move on the upside. Though the risk here is relatively less than straddle but the maximum profit obtainable is also less.

Here is the pay-off of Strangle of PNB

Pay-off for PNB Strangle

Update on PNB Strangle Strategy post the Earnings Day Report:

Here as well we calculate the Profit/Loss (P&L) of the Strangle strategy of PNB by calculating the difference between the original premium and premium post-results. So, we check the premium of 185 call & 155 put options which we have shorted (hypothetically) before the result.

1 PNB 185 call option  premium = 1.5 (call price) X 3500 (lotsize) = 5,250

1 PNB 165 put option  premium = 0.3 (call price) X 3500 (lotsize) = 1,050

Total Premium = 5,250 + 1,050 = 6,300

Profit/loss = 9275 (Original Premium) – 6300 (Premium post-result) = 2975

So, we gained a profit of Rs 2975 on the strangle strategy. Theoretically, if you hold this position till expiry and the stock price stays within 155 -185 range you can get the maximum profit of Rs 9275 but since we want to square-off immediate post the results it is wise to take the profit and move on to the next trade.

So which strategy to choose?. It all depends on your risk appetite. Straddle strategy is risky but there is more profit. Strangle strategy is relatively less risky than Straddle but has less profit. Choose the strategy wisely and be very very aware of risks.

 

ANDHRABANK

Andhra Bank has an IVP of 95 and is ideal for earnings day options strategy.

Straddle of Andhra Bank

At current time, ANDHRABANK spot price is quoting at 69.7 and nearest ATM option strike is 70. So, we sell one 70 put option and one 70 call option.

1 ANDHRABANK 70 call option  premium = 2.1 (call price) X 10000 (lotsize) = 21,000

1 ANDHRABANK 70 put option  premium = 2.5 (call price) X 10000 (lotsize) = 25,000

Total Premium = 21,000 +25,000 = 46,000

46,000 is the total premium obtained by selling the ANDHRABANK straddle. The maximum profit obtainable from this strategy is the total premium received and will happen when the stock price at expiry is 70.

This strategy will start losing money if the stock moves & expires below 65.4 (-6.17%) on the downside or above 74.5 (+6.89) on the upside.

Here is the pay-off of Straddle of ANDHRABANK

Pay-off for Andhra Bank Straddle

Update on Andhra Bank Straddle Strategy post the Earnings Day Report

Profit/Loss (P&L) of the Straddle strategy of Andhra Bank calculated as difference between original premium before results & premium post-results.

1 ANDHRABANK 70 call option  premium = 1.1 (call price) X 10000 (lotsize) = 11,000

1 ANDHRABANK 70 put option  premium = 2.6 (call price) X 10000 (lotsize) = 26,000

Total Premium = 11,000 +26,000 = 37,000

Profit/loss = 46,000 (Original Premium) – 37,000 (Premium post-result) =9000

A profit of Rs 9000 on the straddle options strategy post-results due to crushing of the IVs & the resultant drop in premiums of options.

Strangle of Andhra Bank

At current time, ANDHRABANK spot price is quoting at 69.6. So, we sell one 1SD move OTM strike 75 call options & one 1SD move OTM strike 62.5 put option.

1 ANDHRABANK 75 call option  premium = 0.75 (call price) X 10000 (lotsize) = 7,500

1 ANDHRABANK 62.5 put option  premium = 0.35 (call price) X 10000 (lotsize) =3,500

Total Premium = 7,500 +3,500 = 11,000

11,000 is the total premium obtained by selling the ANDHRABANK strangle. The maximum profit obtainable from this strategy is the total premium received and will happen when the stock price at expiry is between 62.5 and 75.

This strategy will start losing money if the stock moves & expires below 61.4 (-11.78%) on the downside or above 76(+9.2) on the upside.

Here is the pay-off of Strangle of ANDHRABANK

 

Pay-off for Andhra Bank Strangle

Update on Andhra Bank Straddle Strategy post the Earnings Day Report

Profit/Loss (P&L) of the Straddle strategy of Andhra Bank calculated as difference between original premium before results & premium post-results.

1 ANDHRABANK 75 call option  premium = 0.3 (call price) X 10000 (lotsize) = 3,000

1 ANDHRABANK 62.5 put option  premium = 0.3 (call price) X 10000 (lotsize) = 3,000

Total Premium = 3,000 +3,000 = 6,000

Profit/loss = 11,000 (Original Premium) – 6,000 (Premium post-result) =5000

A profit of Rs 5000 on the strangle options strategy post-results due to crushing of the IVs & the resultant drop in premiums of options.

As you can see in case of Andhra Bank both short straddle & short strangle strategies have yielded profit of varying degrees.

Take-Away

Options strategies on both PNB & Andhra Bank yielded a small loss in Straddle PNB while all three others have yielded profit. The loss in Straddle in PNB is mainly due to strong up-move in PNB post-results but Strangle PNB still yielded profit due to larger protection range. In case of Andhra Bank, both strategies have yielded profit with profit amount being higher in Straddle than Strangle strategy. In short, Straddle strategy has higher profit potential but relatively lower probability of profit due to smaller protection range while Strangle has lower profit potential but higher probability of profit due larger protection range. So choose your strategy wisely depending up on your risk appetite.

Posted in Options, Stocks.

4 Comments

  1. What if we buy call and put option of ATM strike 5-6 days before results and sell a day ahead of results? options premium would shoot up because of volatility.

  2. Pingback: Buying Options into Earnings Results Day - Implied Volatility Play | TradersLounge

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