Playing earnings with backspread

[akivak]

Recently I started playing earning with backspreads. Two examples:

Bought PCLN backspread (sold 1 240 call, bought 2 250 calls) one day before earnings when PCLN was at $233. The cost was $1.75. PCLN moved 18% after earnings, the backspread was sold for $16 – 814% return on debit and 212% return on margin.

Bought CRM backspread (sold 1 100 call, bought 2 105 calls) one day before earnings when CRM was at $97. The cost was $0.60. CRM moved 12% after earnings, the backspread was sold for $3.30 – 450% return on debit and 48% return on margin.

The beauty of this strategy is having an unlimited upside potential with very little risk. If you close it right after the earnings, your loss is limited to the debit paid even if the stock moves lower. In most cases, you should be able to recover at least part of the debit, but in any case, the required debit is usually very low. The breakeven point is usually only 3-4% move higher. Compared to buying straight call, the required capital is usually dramatically lower.

Any thoughts?

 

[mushinseeker]

only concern is vega for the bs.

Spread might lose big time post earnings iv drop

 

[JJacksET4]

Quote from akivak:



Bought PCLN backspread (sold 1 240 call, bought 2 250 calls) one day before earnings when PCLN was at $233. The cost was $1.75. PCLN moved 18% after earnings, the backspread was sold for $16 – 814% return on debit and 212% return on margin.

If you close it right after the earnings, your loss is limited to the debit paid even if the stock moves lower.

Any thoughts?

I left the PCLN example in to show - the loss is not limited to the debit if the move goes to the higher strike and IV falls (esp. if time value was now nill), right? Pretend PCLN had gone to 249 for example and pretend it was expiration day. The 240 calls would be $900 against you and the $250s would be worthless. Yes, you can avoid this by not doing these backspreads the Thurs eve./Fri morn before expiration, but the point is that it is possible for the lower strike calls to gain/maintain value while the further strikes (that you have 2X of) lose value due to time decay/IV loss - normally this would be worst if the stock moves ITM on the shorts, but is still OTM for the long calls and the time left is very short and/or IV falls enough.

That all being said, good trades there, especially the PCLN one!

JJacksET4

 

[tradingjournals]

Quote from akivak:


Bought CRM backspread (sold 1 100 call, bought 2 105 calls) one day before earnings when CRM was at $97. The cost was $0.60. CRM moved 12% after earnings, the backspread was sold for $3.30 – 450% return on debit and 48% return on margin.
?

If there is a margin, it would mean the risk is not limited to the debit.

 

[akivak]

Quote from JJacksET4:

I left the PCLN example in to show - the loss is not limited to the debit if the move goes to the higher strike and IV falls (esp. if time value was now nill), right? Pretend PCLN had gone to 249 for example and pretend it was expiration day. The 240 calls would be $900 against you and the $250s would be worthless. Yes, you can avoid this by not doing these backspreads the Thurs eve./Fri morn before expiration, but the point is that it is possible for the lower strike calls to gain/maintain value while the further strikes (that you have 2X of) lose value due to time decay/IV loss - normally this would be worst if the stock moves ITM on the shorts, but is still OTM for the long calls and the time left is very short and/or IV falls enough.

That all being said, good trades there, especially the PCLN one!

JJacksET4

I completely agree that the expiration should be at least few weeks, so IV doesn't fall that dramatically. The margin is for the worst case scenario which is underlying at the long strike, stays there and you hold untill expiration. Fortunetely, both trades went very well for me, I'm just trying to understand what is the worst case scenario assuming I'm closing the trade right after the earnings.

 

[JJacksET4]

Quote from akivak:

I completely agree that the expiration should be at least few weeks, so IV doesn't fall that dramatically. The margin is for the worst case scenario which is underlying at the long strike, stays there and you hold untill expiration. Fortunetely, both trades went very well for me, I'm just trying to understand what is the worst case scenario assuming I'm closing the trade right after the earnings.

Well, worst case scenario in general would be movement towards the long strike and large IV drop, which could happen even if there was still some time left. You just have to use an options calc to see what the pricing would be. For example if PCLN had went to $249 and the IV dropped quite a bit, maybe something like this:
Short 240 call = $1300
Long 250 call = $500
Loss would be $300 plus the $175 debit.

One way to try minimize a large IV drop I suppose would be to see if the IV is overly inflated as earnings has approached. Check what the pricing is likely to be if the IV returns to the "normal" IV that it was a few months back (or use the 52 week low IV and see what that would do).

Also, a person could make the case that losing the entire $175 debit in itself isn't such a good thing as that is a 100% loss on the expense. In other words if you did a number of these trades and the stock always went down, eventually the losses would add up - some people might prefer to always do these for "even", but they may have to go further OTM and/or use lower IV stocks.

The only other thing I would add that would be rare but to be careful of would be for example a say a stock @$69 - you sell 70 strikes and buy 80 strikes 2 weeks before earnings and the co. comes out with the report and whatever the earnings were announces they are being bought out for $79 for example. That would be ugly - IV could fall near 0.

JJacksET4

 

[spindr0]

On an expiration basis, the risk is the difference in strikes plus the debit cost of the position. For a few day/week hold, IV contraction and time decay are significant factor.

For an overnight earnings play, time decay is irrelevant and IV contraction is a factor but not as bad as you'd think because it quantitatively affects the OTM contract less per contract. IOW, it's less than 2:1

So as akivak suggested, as compared to a single long call it's a lower risk way to play an overnight big directional move (tends to have a better risk/reward ratio).

So all you need to do is find stocks that will move a lot and predict (guess?) which way it will go.

 

[spindr0]

Quote from JJacksET4:

- the loss is not limited to the debit if the move goes to the higher strike and IV falls (esp. if time value was now nill), right? Pretend PCLN had gone to 249 for example and pretend it was expiration day. The 240 calls would be $900 against you and the $250s would be worthless. Yes, you can avoid this by not doing these backspreads the Thurs eve./Fri morn before expiration, but the point is that it is possible for the lower strike calls to gain/maintain value while the further strikes (that you have 2X of) lose value due to time decay/IV loss - normally this would be worst if the stock moves ITM on the shorts, but is still OTM for the long calls and the time left is very short and/or IV falls enough.

It's a moot point because backspreads aren't viable the day before/the day of expiration because the OTM leg is usually almost worthless by then.

 

[talontrading]

Really doesn't strike me (lol) as an appropriate strategy for two reasons:

1. It is directional.
2. Much more important: how well do you guys know what usually happens to ivol around earnings? Backspreads are extremely high vega so you have a lot of sensitivity to ivol, which makes this strategy breakeven at best over a large sample size around earnings.

The OP needs to remember that options are at least fairly priced in almost every imaginable circumstance. If buying a straddle / strangle is a fair bet, then ratios also will be fairly priced. There is no free lunch -- you have to be right on both direction and vega in ratios.

So, as for OP's question: nope. no good.

Quote from spindr0:

On an expiration basis, the risk is the difference in strikes plus the debit cost of the position. For a few day/week hold, IV contraction and time decay are significant factor.

For an overnight earnings play, time decay is irrelevant and IV contraction is a factor but not as bad as you'd think because it quantitatively affects the OTM contract less per contract. IOW, it's less than 2:1

So as akivak suggested, as compared to a single long call it's a lower risk way to play an overnight big directional move (tends to have a better risk/reward ratio).

So all you need to do is find stocks that will move a lot and predict (guess?) which way it will go.

 

[spindr0]

Quote from talontrading:

Really doesn't strike me (lol) as an appropriate strategy for two reasons:

1. It is directional.
2. Much more important: how well do you guys know what usually happens to ivol around earnings? Backspreads are extremely high vega so you have a lot of sensitivity to ivol, which makes this strategy breakeven at best over a large sample size around earnings.

The OP needs to remember that options are at least fairly priced in almost every imaginable circumstance. If buying a straddle / strangle is a fair bet, then ratios also will be fairly priced. There is no free lunch -- you have to be right on both direction and vega in ratios.

So, as for OP's question: nope. no good.

The OP is making an overnight directional bet on an earnings play where he expects a big move. Granted, it's a huge expection. IMO, there are better ways to play the EA but in the context of the OP's bet, I agree with him that the backspread can be a better choice than the outright long call.