Earnings Straddle - Why Not Buy Way Ahead of Time?

[qlai]

Hello,
I was watching a video where the guy was describing buying a straddle weeks prior to earnings and closing one day prior to earnings. The claim was that it's very likely for the IV to increase substantially. I googled but didn't find much on this. But below article has some points I don't quite understand:

1. Why is IV more likely to increase? It makes sense conceptually, but shouldn't it be already priced in be the market? I've read some other article which claimed that it increases enough to cover time decay. However, they also mentioned that it's possible for IV to decrease as earnings approach(especially if company makes some statement).

2. I don't understand why stock moving OTM is bad. Assuming IV stays at same level, one side of the trade should gain more than the other loses, isn't this the whole point of straddle?

3. So it sounds to me that it should be pretty low risk strategy with good payout even if not often you get home runs.

"So then you might ask why don't we buy the straddle way ahead of time then? Like a few weeks before the earnings release?

Well, that is possible but what is going to happen is that the stock might move in either direction quite significantly even before earnings release, inclining your straddle to one side, making it no longer a fair weighted straddle by the time of earnings release. That means the straddle would likely only profit if the stock moved in the same direction due to the delta of the straddle being inclined in the direction that it had prior to earnings release, so you are actually not making a fair up and down bet anymore but a one sided bet more or less.

Now, since volatility builds up towards earnings release, won't we get a free ride to profit by buying the straddle a few weeks ahead of time and watch the extrinsic value increase? Well, the catch here again is that the stock price would very likely move quite significantly leading up to earnings release and the volatility build up affects at the money options more than any other options. By which time, your position may be so far out of the money that you may not stand to benefit much from any extrinsic value increase. So, again, no free money.

In fact, Goldman Sachs once ran a research on this and found that only about 56% of earnings straddles make a profit and even that, the average profit was only 2%, which is impossible to profit from after commissions most of the time."

http://www.optiontradingpedia.com/the_problem_with_earnings_straddle.htm

 

[Wheezooo]

Hello,
I was watching a video where the guy was describing buying a straddle weeks prior to earnings and closing one day prior to earnings. The claim was that it's very likely for the IV to increase substantially. I googled but didn't find much on this. But below article has some points I don't quite understand:

1. Why is IV more likely to increase? It makes sense conceptually, but shouldn't it be already priced in be the market? I've read some other article which claimed that it increases enough to cover time decay. However, they also mentioned that it's possible for IV to decrease as earnings approach(especially if company makes some statement).

2. I don't understand why stock moving OTM is bad. Assuming IV stays at same level, one side of the trade should gain more than the other loses, isn't this the whole point of straddle?

3. So it sounds to me that it should be pretty low risk strategy with good payout even if not often you get home runs.

"So then you might ask why don't we buy the straddle way ahead of time then? Like a few weeks before the earnings release?

Well, that is possible but what is going to happen is that the stock might move in either direction quite significantly even before earnings release, inclining your straddle to one side, making it no longer a fair weighted straddle by the time of earnings release. That means the straddle would likely only profit if the stock moved in the same direction due to the delta of the straddle being inclined in the direction that it had prior to earnings release, so you are actually not making a fair up and down bet anymore but a one sided bet more or less.

Now, since volatility builds up towards earnings release, won't we get a free ride to profit by buying the straddle a few weeks ahead of time and watch the extrinsic value increase? Well, the catch here again is that the stock price would very likely move quite significantly leading up to earnings release and the volatility build up affects at the money options more than any other options. By which time, your position may be so far out of the money that you may not stand to benefit much from any extrinsic value increase. So, again, no free money.

In fact, Goldman Sachs once ran a research on this and found that only about 56% of earnings straddles make a profit and even that, the average profit was only 2%, which is impossible to profit from after commissions most of the time."

http://www.optiontradingpedia.com/the_problem_with_earnings_straddle.htm

All those words, and never the word Theta.

...and the guys that write that research, traders there ignore.

 

[qlai]

All those words, and never the word Theta.

I read in another article, and mentioned in my post, that increase in IV is usually enough to counter balance theta. So the straddle could gain, but usually doesn't lose much. That was the claim.
You are saying theta will generally outweight any increase in IV. Decay is guaranteed to happen, while the rest is a coin toss? Thanks for your input.

 

[Wheezooo]

"You are saying theta will generally outweight[sic]"

Offset. To the extent is a conversation in itself. Nonetheless, to present a strategy and ignore its cost is irresponsible.

 

[jamesbp]

Hello,
I was watching a video where the guy was describing buying a straddle weeks prior to earnings and closing one day prior to earnings. The claim was that it's very likely for the IV to increase substantially. I googled but didn't find much on this. But below article has some points I don't quite understand

There is a danger of confusing IV and Option Prices, where IV can increase over time, but option prices remain the same.

For example;
... with earnings, the expected move for a known binary event is priced in ahead of the event
... the ATM straddle price represents approximately the 1 standard deviation expected move
... if the expected move / ATM straddle price remains relatively fixed prior to the earnings date, then IV will increase as time ticks on
... although IV has increased ... the ATM straddle price remains relatively static

 

[ffs1001]

@qlai, the best advice I can give you (as someone who has traded pre-earnings straddles for 3 years) is to have a look at the Steady Options subscription service. These types of straddles are one of their main trades types. You can see the performance history of the trades here :

https://steadyoptions.com/performance/

 

[TheBigShort]

There are 2 ways to actually trade these.

1) Value approach - You convert IV to an event vol and compare that event vol against previous event vols. You also have to consider ambient vol so your gamma gains can outweigh your theta loss.

2)Momentum approach - You build a model that tells you what companies are more likely to see an increase in event vol as we get closer to the date. For example, if a company had REALLY bad earnings last quarter, this quarter there will most likely be some extra risk premium before the event.

I prefer the value approach and have built a custom screener for it.

What steady options are doing, is sketchy, to say the least. There are multiple threads on this forum where we explain to Kim what he is doing is wrong.

 

[gaussian]

1. Why is IV more likely to increase? It makes sense conceptually, but shouldn't it be already priced in be the market? I've read some other article which claimed that it increases enough to cover time decay. However, they also mentioned that it's possible for IV to decrease as earnings approach(especially if company makes some statement).

This is a phenomenon of stocks. As more news comes out and the market processes this news people get more anxious and start buying up significantly more insurance on their positions. This drives up IV.

2. I don't understand why stock moving OTM is bad. Assuming IV stays at same level, one side of the trade should gain more than the other loses, isn't this the whole point of straddle?

If the stock doesn't move (your straddle is OTM) there will be a subsequent loss in IV as the market processes the earnings information (called the IV "crush"). This will kill any positional profit you had. The IV in a long earnings straddle never stays put. It will crush with certainty right after.

3. So it sounds to me that it should be pretty low risk strategy with good payout even if not often you get home runs.

Yes, it is a good strategy - just make sure to close it before earnings.

All those words, and never the word Theta.

...and the guys that write that research, traders there ignore.

Theta isn't THAT important in an earnings straddle unless you're trading the near month weeklies. The theta loss will be eclipsed by the rise in IV (this can also be seen when you buy zero day ATM straddles as the stock begins to pin).

Offset. To the extent is a conversation in itself. Nonetheless, to present a strategy and ignore its cost is irresponsible.

While you are factually correct I don't think it's material here. I do agree though, the author should at least mention it even if it does generally get eclipsed by vega if only for completeness' sake.

In fact, Goldman Sachs once ran a research on this and found that only about 56% of earnings straddles make a profit and even that, the average profit was only 2%, which is impossible to profit from after commissions most of the time."

I would be interested in this study because 56% success rate is actually not terrible with proper risk management.

 

[qlai]

Found related thread on ET
https://www.elitetrader.com/et/threads/best-time-to-buy-strangle-straddle.323248/

 

[Wheezooo]

"This is a phenomenon of stocks. As more news comes out and the market processes this news people get more anxious and start buying up significantly more insurance on their positions. This drives up IV."

No, it's simple mathematics and understanding the granularity behind reverse engineering volatility. 30 days to expiration, an expected event makes you expect vol the final 5 days will be 100, the rest of the month is 25. That vol gets blended. In this instance vol would be 37.5 (obviously this is not how vol blends, nor how calendars function, but for illustration purposes that makes no difference). This is why IV will look too high compared to HV. Now each day one of those 25's rolls off, that makes the average higher - tomorrow 37.9, a week from now 42. With 10 days to expry 62. No different than a moving average. This is why you see vol ramp up.

"a long earnings straddle... It will crush with certainty right after."

"Usually yes, but I've seen it stay put and/or go higher, particularly if the time to expry is short."


"The theta loss will be eclipsed by the rise in IV."

Sad to hear there was all that free gamma lying around that I missed. Not sure how though, I was almost always long vol. Unless, maybe the answer has to do with my first comment about those expected high vol days already in the calculation, and the reason why IV most likely looks high compared to HV. So where you are bleeding are the 25 vol days that you payed the blended 37.5 vol for.

So when you look at it this way, first thought appears to be to sell the damn thing. Collect all that irrelevant theta while only losing a little on gamma. Sounds good, but that only works if you can buy back the vol which we already know is ramping up in your face every day.

I can't say it enough, with options, if you see free money, don't get happy - check your shit, you are almost certainly doing something wrong.