Option Strategy During Earnings Season

Option Strategy During Earnings Season

Very often, stock prices can gap up or down on the next opening session, immediately after quarterly earnings are announced. Such directional risk can be largely mitigated by using the underlying Options.

For example, AAPL is announcing its quarterly earnings today after bell. You had earlier Shorted 100 shares of AAPL at $200. Of cos, if you now have an opinion that AAPL may release a set of sterling earnings, you may choose to close off your Short position and that would totally remove all risk. But with no risk, comes no possible rewards.

Since you are already Short 100 shares of AAPL, you want to maximize your potential for profits but remove as much directional risks as possible. Just in case, AAPL gaps up on open the next morning, as a protection, you can establish the following Option position :

200 of Long $200 Call Options

By having Long Calls, any upside gaps next morning will protect your Short stock positions.

Hang on... you only Shorted 100 shares of AAPL, so why buy 200 of AAPL Call Options when 100 seemingly would suffice?

The answer lies in one of the Option Greeks, namely Delta.

At-The-Money options possess 0.5 delta, whereas 1 Short share of AAPL has -1 delta. Therefore, you need 2 ATM options (2 x 0.5) to equal 1 stock share.

Portfolio Recap :

Short 100 shares AAPL @ $200
Long 200 $200 Call Options

GREEKs Profile :

Delta : 0 (Short 100 shares = - 100 deltas, Long 200 Call Options = +100 deltas)
Gamma : +0.06
Theta : - 0.24
Vega : +0.40

Note that Delta is 0, which means you will not gain or lose no matter how AAPL price moves the next morning. You have effectively removed directional risks arising from earnings announcement. At least this is how it will appear.

In reality, Delta of these 200 Call options will change, when AAPL price moves away from $200 mark. The Delta will change because of Gamma. The overall value of the Long Call will also be affected by Theta and Vega, which are also NOT zero.

If you were Long 100 shares of AAPL, then by going Long 200 options of $200 Puts, will achieve the same direction neutrality to your portfolio. The overall Delta will be again 0, and the remaining GREEKS will largely be the same as above.

We can discuss the impact the remaining Greeks have on this portfolio later. Please feel free to chuck in at any time.

But for now, you can appreciate that using Options, you can immediately remove a chunk of directional risks, without having to liquidate the stock position.

Stock Dividends and Its Impact on Options

Stock Dividends and Its Impact on Options

Although dividend is not a Greek component of any Option, it has a direct impact on the values of Calls and Puts. For this reason, it is important to understand how dividend payouts positively or negatively impact Option values.

I will refrain from a lengthy post on this topic, in part because I'm still struggling to understand the technicalities myself.

Aside from the actual reasoning and explanation of how dividend payouts affect Calls and Puts, it is at least important to note this general phenomenon.

On Ex-Div Date (commonly known as XD to Singapore traders/investors) :

a) ITM Call values will be lower
b) ITM Put values will be higher

Deep OTM Calls and Puts will largely be unaffected by dividend payouts.

It is also for this reason that a day before XD, open interests and trade volume for these ITM options will see gigantic spikes. It has nothing to do with market place opinion on direction of the underlying price movement. Thus, trying to decipher the directional bias based on open interests of the Calls and Puts in especially just before XD will be misleading and inaccurate.

If there's anyone who can succinctly explain this phenomenon, please post here. My brain is all jammed up putting together the details of this outcome. Thanks in advance.

Why Conversions and Reversals Cause Stock Volume Spikes on Expiration Days

to truly understand the cause of volume spikes on Option expiration days, we must comprehend the Put-Call Parity structure that is associated with Conversions and Reversals.

recall an earlier discussion about Put-Call Parity equation. in a gist, a Put is a Call and a Call is a Put. if this sounds confusing, you are on the right track 8-)

[u]Put-Call Parity[/u]
Call = Put + Stock - Strike + Interest - Dividend

and by rearranging this formula,

Long Stock = Long Call - Short Put + Option Strike Price - Interest (carrying cost) + Dividend (of stock)

in otherwords, any Long stock position can be synthetically created by using Options and using some combination of Options, Long or Short stock positions can be synthetically created. now, this is a powerful tool and knowledge.

Market Makers (MM) seize this knowledge to their advantage. In fact, Conversions and Reversals are strategies utilized by market makers every trading day. they have to do so, because they have to accept all orders, both buy and sell. in order to make a profit, they cannot always choose only to buy or sell. almost all market makers will buy and sell throughout the trading session. one of their primary functions is to provide liquidity and get rewarded. however, at times, they find themselves too Long or Short, and risks mount. to defray risks, they "convert" their stock positions into synthetically opposite trades. by doing so, they remove directional bias without having to liquidate existing stock positions yet.

so, if a MM is uncomfortable being too Long XYZ at $100, he/she will immediately Long 100 Put and Short 100 Call to form that Conversion. the MM "converted" his Long stock position into synthetically short stock position, removing his directional risks.

now, come that Friday expiration, the synthetic Short stock (Long Put and Short Call) position could well need to be exercised, if XYZ falls below $100. the market makers does so and automatically, that Long XYZ stock gets sold in the open exchange. even if XYZ price was higher than $100, the fact that those options are expiring, exposing the MM with Long stock directional risks, these Long stock positions will be liquidated. this action contributes to the increase stock volume transactions. MMs are in the business of speculating market directions.

the same can be explained about Reversals, which is

Short Stock + Long Synthetic Stock (ie. Long Call + Short Put)

on Option expiration day, if those Long Calls are exercised, the relevant Stock will be purchased.

retail players do not usually enact Conversions and Reversals. only MMs do so, in order to profit from

a) buying the Bid and selling the offer
b) arbitraging the difference in price of direct stock purchases/selling and synthetic shorts/longs
c) interest rate outlook; conversions are interest rate bearish and reverses are interest rate bullish strategies

these advantages above are very tiny, sometimes less than 5 cents but due to the size of their transactions and very low to near zero commissions on trades, they can make substantial profits if they get them right.

MMs are by far the single largest contributor to stock volume transactions...retailers, commercials and in-house traders trade with them.

so, please don't try Conversions and Reversals unless you are fully aware of the intricacies involved...

and so, now we know the reason for the consistent Stock volume spikes on Option expiration day...because Conversions and Reverses are closed off by MMs.

What is a Conversion?

simply explained, a Conversion is a Long stock AND a synthetic Short position; for example :

say AAPL is at $200 now.

Long AAPL @ $200 (this is the Long stock position)
Short AAPL 200 Call + Long AAPL 200 Put (this combo is the Short synthetic stock)

If stock price moves up, the Long stock position profits but the Short synthetic stock position loses about the same amount, resulting in very little fluctuation in the P/L.

Conversions are as good as flat positions (not totally, but very close). Hence, there is no directional risk in Conversions.

since Conversions can hardly make money (not that it can't, just rather difficult), the question that is begging to be asked is "why would anyone establish a Conversion?"

answer: no retail player in the right mind, except to temporarily mitigate all directional bias risks, should establish such Conversions.

but this doesn't yet directly explain why Conversions and Reversions cause stock markets activities to spike on expiration days...

Conversions and Reversals

Conversions and Reversals
every last but one Fri of the month, across the board, stock volume transactions rise above average daily transactions. why does this happen?

most people will cite that it is because it is this day that equities and index Options and sometimes Futures expire... but so what that these derivatives expire?

why is it that when these derivatives expire, the overall trading volume of equities markets rise? aren't these derivatives separate classes of assets that can be traded independently from stocks, nevermind the existing relationship? who is to dictate that i must buy or sell stocks when i trade options? for most options traders, they take positions in Options without accompanying stock positions; such as Long Call, Short Put, etc and hence liquidating those options on expiration day should have no material impact on volume of stocks traded. of cos, those who BUY/SELL-Write (eg, Covered Calls, married Puts) will likely close off their stock positions as they square off their Options as well. but these are arguably a significantly smaller group in the Options trading space. consequently, their overall trades should not consistently rake up the increased volume that we witness on every expiration day.

so, then, why do stock market transactions volume spike on such expiration days?

the answer lies in Conversions and Reversals....

Explaining Risks through Greeks

let's use SPY trading at $108.20 with 11 days to expiration....the following Greeks for a Long Nov 109-strike Call are :

Delta : +0.41
Gamma : +0.1
Theta : -0.06
Vega : +0.08

we move on to more specific Greek talk..

the above is a Bullish directional option position, which was established by paying a premium of ~$1.91 or $191 for 1 contract size.. this is evident from Delta, which is +ve 0.41.. this also represents the position's biggest risk..

Delta Risks
why is this +ve 0.41 delta, the biggest risk? for one primary reason; if SPY moves up or down 1point, this position gains or loses $41 (0.41 x 100)respectively. this is a 21.5% fluctuation in the P/L; a significant % by any measurement.

therefore, before anyone goes Buying single directional options, whether Long Calls or Long Puts, the trader MUST understand Delta risks... which is most prevalent for Long Calls and Puts.

Gamma Risks
a +ve gamma is always associated with any Long options. remember, +ve gamma has nothing to do with directional bias. this means, one can Long Call or Long Put, such positions will always yield a +ve gamma. as long as you BUY an option, you will be +ve gamma; and conversely, as soon as you are Short(sell or write) an option, you will be -ve gamma.

gamma is best explained vis-a-vis delta. they are a pair of Siamese twins...because delta of an option position changes ONLY because gamma changes it. if gamma is 0(zero), no amount of movement of the underlying will change the delta value of that option !!!

in this example above, this Long SPY 109 Call assumes a +ve 0.1 gamma risk. how so? recall that gamma changes delta. gamma either makes a delta bigger or smaller. in this example, if SPY moves up 1 point, this Long 109 Call delta becomes +ve 0.51 (0.41 + 0.1) and if SPY drops by 1 point, the same Call option value will drop by +0.31 (0.41 - 0.1). of cos, this is a simplified calculation, becos gamma itself changes as SPY moves about. but we will keep it simpler here.

hence, if SPY moves up by 1 point, gamma helps the 109Call value tremendously by pumping the delta value up by ~24%(from 0.41 to 0.51),making this an even greater delta risk play. similarly, if SPY drops by 1 point, the option value will drop by ~23%..

therefore, if you are very bullish and decide to purchase a Long Call option, you want a large enough +ve gamma, to help you increase your +ve delta. BUT you had better be right on your directional bias, because if you were wrong, a large +gamma can also quickly erode your +ve delta of your Long Call option position, making it less sensitive of subsequent upward price movement of the underlying.

this, in a gist, is what gamma risks is all about...

Theta Risks

Theta is defined as the Rate of "Decay" of any option's extrinsic premium.

A side note on option premium. All options value are composed of intrinsic and extrinsic values. For example, recall that this Long SPY Nov 109 Call is valued at $1.91, when SPY was trading at $108.20. This is an OTM Call. This $1.91, the value of this Call option, consists of $0 Intrinsic value and $1.91 of Extrinsic value.

All OTM options contain only extrinsic values. ONLY ITM options contain intrinsic values.

Thus, when you purchase this 11days to expiration Long SPY Nov 109 Call, and paid $1.91, all of this is "time" fee. This is "fair" because option is a leveraged instrument, allowing you to gain control of 100 SPY shares at a fraction of the cost of actually buying SPY shares. The tradeoff, is that you pay such extrinsic value, build into the SPY options. Option trading epitomizes the saying "There ain't never a free lunch in this world !!".

Theta affects ONLY the option extrinsic value, NEVER the intrinsic value. In this example, there is $191 worth of premium to be decayed.

So, as with the above example, with a -ve 0.06 Theta, with every passing day, this option decays by $6 (0.06 x 100). You would have noticed an anomaly by now. Given that this option has only 11 days to expiration, doesn't it mean that there is only $66 ( $6 x 11 days) of decay, but with an extrinsic value of $191. So how is this possible? This is possible, because Theta does not decay in a Linear fashion. In fact, the rate of decay (aka Theta) becomes larger as time to expiration nears. It accelerates very aggressively in the last days and last moments of the option's life !!!

A very important lesson about Theta is this...

Supposing you did purchase this Long SPY Nov 109 Call and paid $1.91 and on the final day of expiration, SPY settles at $110. One would imagine making a profit from this position. This cannot be further from the truth. In fact, if SPY had ended at $110 at expiration day, this position would make a loss. By how much?

Value of 109 Call option on expiration, with SPY trade close at $110, will have a value of exactly $1. That Long SPY Nov 109 Call can be exercised into 100 shares of SPY shares at $109 and immediately be sold off in the open market for $110, profiting $1. Of cos, this Call option will be valued at $1 exactly, no more, no less..."No free lunch mantra, remember"....

So, with this SPY Call worthy of $1, and yet you paid $1.91 for it 11 days ago...tell me, how could be be a profitable trade? It is a bigger-than-burger-king-big-whopper loss of 48% !!!

But wait...just when you think this is bad...I've got worse news...Supposing SPY on expiration day closed off at $109, that Long SPY Nov 109 Call would be worth $0 !!! All of that $191 paid for that Long Call option, miraculously vanished into thin air. Talk about frustration! You've got your market direction right, no doubt about that. You entered the trade when SPY was $108.20, and 11 days later, SPY did rise to $109, and yet, you lost 100% of your capital on this trade. Ain't this a sucker trade !! Bitch it all on -ve Theta.

Now, I believe Theta has your attention and respect (sing that song...R-E-S-P-E-C-T by Donna Summers) .......this is what Theta risks is all about.... in this case, contrary to popular saying, time is not money...instead, time is your foe, when you are -ve Theta...

Bull Call Spreads with Positive Theta

Bull Call Spread

We know that a Bull Call spread is a bullish position, with limited profit potential and losses. It this sense, credit Call spreads are limited risks positions...

A Bull Call spread consists of Long Call and Short Call of a higher Strike price.

Let's take AAPL as a case study....with AAPL price trading at ~$196

Some traders like to establish

A) Long 200 Call + Short 220 Call and pay $5.41 premium
vs
B) Long 180 Call + Short 200 Call and pay $15.38 premium

P/L for A)
Max Profit = $14.59 ( $20 - $5.41)
Max Losses = $5.41

P/L for B)
Max Profit = $4.62
Max Losses = $15.38

A) has a lot of profit potential and losses are much lesser, when compared to B). Moreover, it costs less to establish A) than B).

QUIZ :

Which of the 2 positions is a better trade, if indeed there's any difference, given the following Greeks:

GREEKS of A)
Delta +43
Gamma +1.5
Theta -7
Vega -11.6

GREEKS of B)
Delta +37
Gamma -1.7
Theta +4.9 >> most are mistaken that Bullish option positions will always yield -ve theta.. clearly not true
Vega - 11