For an options trader, earnings season is the time of year where we really get excited. The opportunities are nearly endless and multiple methodologies can come into play.
IMPLIED VOLATILITY MEAN REVERSION
One of our favorite strategies is an implied volatility mean reversion set up that takes the form of some type of calendar. What is our approach to this type of setup? Since we don’t have the earnings report in front of us, the only things we have to go on are the technicals, the present option prices and past earnings behavior. To a large extent, you can throw out the technicals because the earnings report is going to trump any sort of support or resistance that presents itself on a chart.
IN THE NEWS
This earnings season we are looking at Herbalife (HLF). HLF has been in the news for the last year largely because of the very public feud between Carl Icahn and Bill Ackman. The markets tend to react violently to news in HLF. But, over the past two years, the average move on earnings is only 5.7%. We have to take note that back in May 2012 the stock did drop 20%. We don’t want to leave ourselves in a position where a big move hurts us.
TRADE SET-UP
We are looking for a short calendar which affords us short vega (which we model to revert to a normal level after the report) and long gamma (taking advantage of a big move). We know from the front month option prices that the market is pricing in a one standard deviation move of 11.8%. Does someone know something? The options prices suggest that they do. The average move is 5.7% and the market is pricing an 11.8%? We certainly do not want to get on the wrong end of a short gamma trade.
A trade with a favorable reward to risk scenario would be to sell the monthly May 50/62.5 strangle and buy the weekly May 2 May 50/62.5 strangle.
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