When it comes to playing earnings-based volatility, traders and investors have numerous strategies to choose from. Traders can sell naked options, trade breakouts in the stock by buying or selling shares or use limited-risk strategies to capture potentially over-inflated option premiums.
Strategies designed to take advantage of potentially over-inflated option premiums can be implemented with defined risk parameters. Such strategies may provide traders and investors a means for potentially high returns while keeping risk within their comfort zone.
The iron butterfly can potentially offer investors a way to capitalize on inflated levels of implied volatility while maintaining a defined-risk profile.
Here is how to use an iron butterfly to potentially take advantage of earnings volatility:
- Choose a stock that has an upcoming earnings announcement.
- Check options on the stock for rising levels of implied volatility.
- Stocks that have options trading at IV levels at or near the top of their 12 month range may be candidates.
- Using fundamental and technical analysis, come up with a likely range for the stock to trade in post-earnings.
- Sell the at-the-money straddle and buy the out-of-the-money strangle.
- Manage your position.
While its not quite that simple, these are the basics. By selling the at-the-money straddle, you are potentially capturing significantly over-inflated option premiums. By purchasing the out-of-the-money strangle, or wings, you are capping your risk.
For example, stock ABC is trading at $50 per share and has a heavily anticipated earnings announcement coming out next month. IV levels have been on the rise and the $50 straddle is trading at the highest level seen all year. After analysis, you decide the stock is not likely to move more than $5 up or down after earnings are announced. In fact, you think earnings could be a non-event.
You therefore sell the $50 front month straddle for a premium of $4.00. To manage your risk, you simultaneously purchase the front month $45/55 strangle for a premium of $1.50. You have therefore collected a net overall premium of $2.50.
Ideally, the stock will do very little or even nothing following the earnings release. Should this be the case, the at-the-money straddle may lose value quickly, thus producing a profit.
Even if the stock does move, you may still potentially profit. Because you collected a net $2.50 in option premium, the share price can move up or down by $2.50 at the time of expiration before a loss is produced by the position.
In this case, maximum profit of the $2.50 collected is achieved with the stock staying right at $50 at expiration.
That $2.50 profit is reduced point for point above or below the $50 strike price until the break even points of $47.50 and $52.50 are reached. Above or below these levels, losses will begin to accrue until the strike prices of the long strangle are reached. In this case, losses could accrue from $47.50 down to $45 and from $52.50 up to $55.
If the stock goes beyond $45 or $55, losses are no longer accrued as the long call and long put from the strangle kick in.
The iron butterfly can be a useful strategy for taking advantage of potentially over-inflated option premiums. It is imperative that investors do their homework first. For best results, only use the strategy when IV levels are elevated and you determine (through analysis) that the stock is likely to trade within a relatively tight range.
