The Earnings Ratio Condor

Just as it is common for at-the-money implied volatility to rise leading up into an earnings announcement (as discussed in The Earnings Straddle in Different Flavors), it is also common for the curvature of the volatility skew to become more pronounced.  This latter phenomenon is perhaps less common than the former and is certainly more difficult to identify (and to trade, for that matter), but that is not to say that it doesn’t exist and can't be exploited.

Allow to me to explain with an illustration.  Below is a mockup of the vertical skew of a typical big name stock going into earnings.

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The Earnings Straddle in Different Flavors

A common phenomenon during earnings season is for implied volatility (IV) to rise in anticipation of the event.  The most common strategy to capitalize on this is the purchase of an ATM call and put: the long Straddle.  The Earnings Straddle however, comes in different flavors—some with more bite than others.

The Vanilla Earnings Straddle

The inexperienced trader will purchase the straddle the day prior to an earnings announcement with the intent of profiting from an explosive move in the underlying.  While these moves often do indeed occur, they are rarely reciprocated with an appreciation of the straddle.

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Hedging with the Ratio Backspread

I know I promised Vertical Spread Adjustment strategies as the next topic.  I’m going to delay it one week and at the request of the people who asked, instead present a written version of the presentation I delivered last weekend in Denver at the Trading Trainer Mastermind.  At the time I was putting my PowerPoint together, we were just entering earnings season.  Given the daily market behavior over the last week has every day behaving like an earnings announcement, it appears an appropriate time to share this hedging strategy.

This past earnings season, I’ve heard a lot of questions about how to best hedge a long trend continuation position thru an earnings announcement.  In my mind, carrying this type of trade thru earnings transforms it into something considerably more speculative than when the trade originated.  This kind of transformation, in general takes form in the expansion of risk.  Since the likelihood of a significant move against the position is large, the amount of capital originally allocated to the position is likely no longer appropriate.    To carry a trade thru earnings on a stock that has a history of significant moves, requires the trader either to reduce capital and/ or hedge against the original position.

Along with just about every Apprentice, I bought into EL when it followed thru on the Reactive Template on April 14th

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