Earnings-Driven Straddle Buys (15:10)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 15, No. 10 on May 25, 2006.

In our last issue, we discussed the viability of buying a stock after event-driven news has caused the stock to gap. The conclusion was that there was a small potential profit there, but we are continuing to gather data on that subject. In this issue, we want to take a different tack: does it make sense to buy straddles on stocks that are about to report earnings? In particular, what about the stocks where traders expect the most action – i.e., those with inflated implied volatility prior to the earnings report? This is not an entirely new subject for this newsletter (reference issues 7:04, 9:20, and 13:16, for example), but it is the first time we’ve addressed this issue in a while. Furthermore, we are still of the opinion that this past quarter saw a new, higher level of earnings speculation than ever before.

For the purposes of this article, we are going to consider stocks whose options were expensive prior to the earnings report, as defined by the fact that they were in the one of the three following reports of volatility that we generate daily: “Volatility Extremes,” “Overpriced: IV > HV,” (both of which are posted to The Strategy Zone daily, and “IV Gain,” a proprietary report that is used for internal analyses that often appear in The Daily Strategist Newsletter.

During the most recent earnings season, there were a total of 101 such situations. In all of these, implied volatility had risen to an extreme level on the day prior to the earnings announcement. In some cases, the rise was long and steady (AMZN, for example). But in many others, the increase in implied volatility occurred on only the day before the earnings announcement.

In the following study, it was assumed that one bought a straddle at the inflated volatility level at the close of the last trading day before earnings were announced. Then the straddle was sold at the close of the subsequent trading day.

On the first trading day after the earnings were announced, the stock made a move (often volatile – 7% was the absolute value of the average move), but implied volatility dropped by 16 vol points, or 28% on average. That is a considerable drop in implied volatility, and thus a rather large move by the underlying stock is required to overcome that “volatility drain.”

From these average figures, we first estimated how the average trade would have fared. We’ll get to the specific trades in a minute, but first we want to get a general estimate of how such a strategy might have fared in this most recent earnings season.

Number of trades: 101

Average absolute value of stock move: 7%

Average implied volatility before earnings: 56.5%

Average implied vol after earnings: 40.5%

Average decline in implied volatility: 16.0 points, or a 28.1% decline

Using the Black-Scholes model, if one bought an at-themoney straddle at a vol of 56.5% and the underlying moved 7% in one day, while implied vol dropped to 40.5%, the straddle would lose 14% on average. That’s not very encouraging, but let’s look at the individual data.

Of the 101 stocks, 39 moved higher after the earnings were announced and 62 moved lower. The average stock “up move” was +5.6%, while the average “down move” was –7.9%. This is fairly typical, I think, as negative surprises – whether they be earnings announcements or FDA hearings – produce larger moves than positive surprises do. The largest single gain was 22% (CLHB) and the largest single decline was –26.9% (SFCC).

When one implements a straddle buying strategy in cases like these, it is often the case that the stock is not near a striking price. A straddle can be made delta neutral in actual practice. However, we used theoretical values to determine the results of straddle buying on these 101 stocks. Specifically, we assumed that a fictional at-themoney straddle was purchased at the composite implied volatility of the stock’s options on the day before the earnings announcement. Then, that straddle was sold at the composite implied volatility of the next day, with the stock having made its post-earnings move.

On “up moves” by the stock, the average straddle buy lost –1.5%, but on “down moves,” the average straddle gained 5.9%. The largest straddle gain was 165% (HTCH), but there were also gains of over 100% in EXPE, CLHB, and INFY. The largest straddle loss was –49%, in HELE. Losses of over 40% also occurred in VOXX, DRTE, OVEN, and MYL. Overall, of the 39 stock “up moves,” only 13 resulted in straddle profits. Of the 62 stock “down moves,” only 26 resulted in straddle profits.

In our prior studies of similar data, we had concluded that buying straddles before earnings announcements was not particularly profitable – gaining only about 9% on average. For this particular quarter, the average straddle gain was only 3.1% – even worse (possibly because implieds were over-inflated as traders had little else to do with their time in a dull market).

This article was originally published in The Option Strategist Newsletter Volume 15, No. 10 on May 25, 2006.