Hello, Power Profit Traders!
Hurricane Ian may have handed Florida 12-foot tidal surges this week, but there’s another surge on the horizon that you’ll actually appreciate.
That Surge is Implied Volatility, and when it rises by triple digits, the implication is money in our pockets.
Our Operation Surge Strike trades yielded 100% winners for the month of September – wrapping up Q2 earnings.
So, I’m now looking forward to a potential windfall from Q3 earnings, which begins in October, and we’ve already launched earnings trades on PM and USB to kick it off.
At times you’ll find me trading calls and puts during earnings, but did you know I also trade them as a combination trade?
The strategy is called a Straddle.
That’s right – it’s possible to simultaneously trade a call and put to reel in profits during earnings season, and there’s a great benefit in doing so.
Trading Straddles into earnings has a two-fold benefit.
- We can make money regardless if the stock rises OR declines sharply.
- We can enhance the returns or even mitigate loss when Implied Volatility rises as anticipated.
Let’s talk about the Straddle strategy, the implications of Implied Volatility and upcoming opportunities.
The Straddle Strategy
To keep it simple for you, keep in mind that when we buy call options, we simply want the stock’s price to rise for us – the sooner, the better.
Alternatively, when we buy put options, we simply want the stock’s price to fall for us – and sooner is better than later applies here as well.
Essentially, if we buy both the call option and the put option (same strike and expiration) we can simply say we don’t care if the stock’s price goes up or down because we’ve got a trade on to cover us in either direction.
Now, there’s a caveat to this – because we’re purchasing both options our investment is larger, and due to the larger investment, we simply need the stock’s price to move more aggressively in either direction.
This is where corporate earnings come into play. Unknowns or uncertainties about corporate reporting can cause speculation, hedging and, therefore, an increase in volatility even before the announcement is made.
There are actually two types of volatility that I want to address when it comes to earnings trading. The first item is stock price volatility – how much a stock’s price may swing. The second item is Implied Volatility (IV), which refers to how much an option’s premium might swing between undervalued and overvalued.
The Benefit of Rising Implied Volatility (IV)
To help you understand how IV benefits Straddle trades, let’s use an arbitrary example. Consider a fancy car that you’ve noticed at the corner car lot with a price tag of $80,000. For weeks you’ve passed by this lot and the cars have been selling for this amount consistently.
After passing the lot today, you notice the price tags have increased to $90,000. You decide to walk in and inquire about the price change. The sales agent informs you that this fancy car will be featured in a blockbuster hit over the weekend and he expects demand to rise.
In your mind it’s the same car, same color, same features, and should be selling for $80,000 as far as you’re concerned.
The same thing can happen with option prices. The stock’s price may not move, and there may still be, say, 28 days until expiration, but the option premiums are inflating. You’re paying more for the same expiration and strike price.
On Monday, you pass the car lot again and the price has fallen back to $80,000. You ask the sales agent why, and the agent tells you the movie got cancelled and is not showing. The demand is simply not going to be there, and as a result the dealer dropped the price back down.
After earnings is announced, the surprise, the shock, the excitement is all but gone, and the inflated option premiums are deflated – in a matter of minutes in some cases.
(MSFT: IV Before/After Earnings Reporting)
The graph above will help you visualize how IV can change. On this Microsoft (MSFT) chart the red line illustrates how IV reacts before and after an earnings report.
The red line represents how IV fluctuates slightly, but then as earnings approaches it rises sharply. Then, after the announcement is over, you can see the IV dropping like a rock – option premiums can be severely deflated… even if the stock’s price doesn’t move on the earnings announcement.
It’s this rising IV, or inflation of option premiums, ahead of earnings that benefits our Straddle trading strategy.
It’s incredible to see how much value is vacuumed out of option premiums after an earnings report. It’s also why too many traders lose money trading through earnings.
Opportunities with Straddles
The software I call Brutus is designed to not only identify potential IV surges on stocks ahead of earnings, but to also tell me the exact day to get into and out of potential IV Surge trades.
Understanding this concept gives us an edge when trading around events like earnings.
Brutus has already given me trading opportunities for the next round of earnings, which starts in October, but there are many more signals for trading opportunities.
I don’t want you to feel intimidated by the Straddle strategy. Hopefully you can see now that it’s simply a combination of buying a call and put at the same time.
Having an understanding of the implications of IV before and after earnings has given us an edge, and it can often be the difference between a winning and losing.
For the month of September all of our Surge Strike Straddle trades were successful, and I’m confident that this next earnings cycle, beginning in October, will produce winners as well.
I’m happy if you can join me for Live discussions on Mondays, Tuesdays and Wednesdays of each week.
Click here and save this link to your Favorites. My sessions start at 12:00 p.m. ET.
Until next time!
Tom Gentile
America’s #1 Pattern Trader
Join Tom each Monday through Wednesday at 12:00 p.m. ET as he discusses a wide variety of trading strategies.
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