Earnings season is upon us, and with it brings increased volatility for those stocks reporting results. Highly anticipated by investors, quarterly earnings announcements can provide important insight into how well a company is doing. These one-day events can be extremely volatile for individual stocks because of the uncertainty surrounding these announcements.
The timing of earnings will affect the pricing of options differently depending when they expire. Because of this, option expiration cycles that encompass an earnings date typically have higher implied volatilities in that cycle. If the market believes a stock might move more following an earnings announcement, that expiration cycle’s implied volatility will be elevated.
The implied volatility of a particular option expiration cycle is made up of normal volatility days, plus any volatility event (earnings) days from now till those options expire. As an earnings announcement approaches, there are fewer normal volatility days and the effect of the earnings event volatility will become more pronounced.
Iron Condors: The Basics
The short iron condor is a risk-defined strategy with characteristics designed to allow a trader to take advantage of elevated option premium during earnings. Just in case you're new to iron condors, let’s go over some of the basics of the strategy.
A short iron condor is a four-legged spread constructed by selling one call vertical spread and one put vertical spread simultaneously, in the same expiration cycle. Typically both vertical spreads are out of the money and centered around the current underlying price. Similar to a single vertical spread, the risk is determined by the distance between the strikes of the vertical.
If the vertical spreads are $2 wide, the risk would be $200 per contract, minus the credit received for selling the iron condor, plus transaction costs. In the best-case scenario, the price of the underlying stays between the two short strikes through expiration, and both vertical spreads expire worthless. This allows a trader to keep the full credit that the iron condor was sold for, minus transaction costs.
Let’s look at a hypothetical example. Suppose a trader would like to create a neutral short iron condor position on XYZ, which is currently trading at $52.50. To create the position, the trader could sell a $47.5 put, buy a $45 put, sell a $55 call, and buy a $57.5 call for a combined credit of $0.70. This would give the trader a $7.50 range between the put, with a low strike at $47.50 and the call, with a high strike at $55, in which the trade could achieve its maximum profit potential. The position would have an upside breakeven level of $55.70 and a downside breakeven level of $46.80, as shown in figure 1. If the stock remains between the short $47.5 and $55 strikes through expiration, the maximum potential profit would be $70 per contract, minus transaction costs (the credit received when the position was initiated). The maximum potential loss would be $180 ($250 max risk - $70 credit received) per contract plus transaction costs.
Earnings Season and Heightened Uncertainty
When volatility levels are elevated, so are the credits that can be collected when selling an iron condor. Any increase in volatility typically expands an option’s premium, which inflates the prices of the individual vertical spreads. No matter where the volatility goes, the risk lies with the underlying moving outside the outer strikes ($45 and $57.5, in the example above), but is defined by the distance between the vertical strikes.
The short iron condor is a strategy to potentially consider implementing in times of uncertainty, such as prior to earnings announcements. This strategy is designed to take advantage of inflated risk premium in a risk-defined manner. By taking this position prior to earnings, a trader is making two basic assumptions:
- Current volatility is elevated and they believe it will decrease once the earnings are released.
- The price of the underlying will remain between the two short strikes of the iron condor after the market has digested the earnings results.
The key is to understand that the market is pricing in what it feels the potential move will be, and a short iron condor can be used when a trader feels the market is overstating the potential move.
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