Earnings play -- short calendar spread

J

jimmyjazz

I am considering a short calendar spread as an earnings play (buy ATM near-term, sell ATM farther out). The underlying appears to be consolidating and a breakout seems likely.

I am never very comfortable trusting the PnL predictions I see on calendars, diagonals, etc. In this case, the predicted max loss is small compared to max gain, and the range in which the trade is a loser at front month expiry is small. Looks too good to be true.

Even if the predicted expiration PnL is optimistic, I am more concerned about the unexpected. What are the "failure modes" prior to expiry for these types of trades? How could I blow up, if at all? One problem I see is if both legs go deep OTM, I might not be able to find a reasonable market for either at front month expiration. I would then be proudly short the back month option, naked.

At this point I am leery to even put on a single contract pair until I know more about the risks involved. Thanks for any advice.
 
Without knowing the underlying its hard to say what the market is pricing, but it's unlikely the market is pricing the option with the max loss/max gain characteristics you are describing. but these are all qualitative statements and for all you know you could be missing something fundamental in the underlying (dividend, etc).
 
The procedure I use to determine if I want to buy or sell a calendar prior to earning is:

-Simulate the date after earnings
-Reduce Ivol to what I believe it will be after earnings-I get my clue from Ivol of options 6 months out
-then I move the stock price and see where my breakeven point, max loss and expected outcome is
-Then determine if the trade has the risk reward I look for based on the move I believe is most likely, or unlikely

Many of our option clients use Silexx Obsidian which makes this analysis relatively easy.
 
No dividend, but I did find a similar thread in which Maverick74 outlined a fairly terrifying event in which back month vol explodes and front month vol remains steady. No thanks! I'm glad I posted.

So -- if I think the underlying will move but I can't say which way, what are some options (heh) that don't have this vol risk? Short fly? I tend to trade directionally, and I usually keep it simple with long options or verticals/diagonals.
 
normally i find that options are fair priced, so it's difficult.

"So -- if I think the underlying will move but I can't say which way, what are some options (heh) that don't have this vol risk?"

a) buy a short and a long option. pretty costly though and only worth if it *really* moves.
b) make a directional trade and buy after the breakout
 
jimmyjazz said:
No dividend, but I did find a similar thread in which Maverick74 outlined a fairly terrifying event in which back month vol explodes and front month vol remains steady. No thanks! I'm glad I posted.

So -- if I think the underlying will move but I can't say which way, what are some options (heh) that don't have this vol risk? Short fly? I tend to trade directionally, and I usually keep it simple with long options or verticals/diagonals.
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I have never seen this occur after earnings, when the back months "explode". Even it were to happen, it would be a rare event and would point to an event in the futures, like with a Biotech announcing a future date with news.
 
That was his point -- the company announces that it will release news after front month expiry but before back month expiry. Back month vol shoots up, and the spread is toast.
 
There is risk in every option spread because they all rely on assumptions. If I choose to buy or sell a calendar before earnings, I would not include that assumption in my math. Just my opinion.
 
Would you agree that verticals, diagonals, and long calendars don't suffer from the same "shit hits the fan" possibility as something like a short calendar?
 
I'm not suggesting that anyone trade calendars. I was only suggesting one way to decide if the trade has risk reward worth allocating toward. Your question is very narrowly defined. I can only answer yes.
 
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