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Buying Volatility Into Earnings

One of my favorite Monday morning reads is the newsletter that comes out from ivolatility.com. They usually list about 4-5 option trade ideas and it gives me a few fresh ideas to start looking at going into the week ahead.

This week they post two interesting ideas around the same strategy: buying into the volatility runup into earnings. Generally, what you see in the options market is a bidup in option premium going into an event; that makes sense-- there is potential for a strong move and a fundamental shift in the name, so investors and traders are willing to protect themselves to the downside (and upside) in the case of a strong move.

But this volatility bidup happens slowly over a few days, and it can lead to an increase of 10% in the implied volatility of the options.

The above chart is a graph of the 30-day implied volatility for RIMM options. You can see that there is a cycle that occurs, with implieds getting bidup going into an event. You would think with this sort of predictiveness, you would make money hand over fist by getting long vol on the runup. Right?

Well, sometimes. There are other factors that go into the pricing of an option, including the underlying movement and time. And if the positive vega move doesn't offset the losses from time decay and other factors, the trade can turn out to be a loser.

Also, not all vol is created equal. You can see a rise in front month implied volatility, but the back month won't move at all. So your option choice will play a role in whether you make money on the trade.

But I like the premise-- if there's an expectation of movement in both direction and volatility, I'd be looking to buy straddles. A straddle is an option strategy where you buy a call and buy a put, and they both have the same strike and month.

Here are the strats from iVolatility:

Instead of trying to guess which companies will beat, our approach to earnings is to look for prospective volatility opportunities. Here are two ideas.

Louisiana-Pacific Corp. ($LPX) 12.86. LPX manufactures and distributes home building products. Since it gapped up above resistance and closed at 9.05 on March 31, 2010 LPX has gone rapidly higher with no indication of correcting. The breakout was accompanied by increased volume and now the options implied volatility is rising. In addition, the building products and home building groups are showing positive relative strength. There is a good chance the strength is due to improved sales and perhaps even positive earnings that are due to be reported on Tuesday May 4, 2010.

In the event the implied volatility continues to rise, we suggest a two-part straddle we call an Earnings Report Volatility Reversal. The plan is to buy a straddle for the rise in volatility and then reverse the position on the day before the earnings report is released. With a current Historical Volatility of 49.44 and with an Implied Volatility Index Mean at 66.78, up from 54.68 last week, our forecast is for another 10-point rise into the earnings report. Here is the straddle.

Buy Aug 12.5 Straddle

Since this is rising implied volatility position, price direction is not the concern. The SU (stop/unwind) is based upon no further rise in implied volatility up to May 3, but the plan is to reverse the position on the day before their earnings report. The risk is an early release of the report so the date needs to be checked often, especially on Friday April 30, 2010. In the event the stock continues higher before the position is reversed (most likely), a higher strike will be needed for the short straddle second part of the plan.

The Home Depot, Inc. ($HD) 36.39. Also in the relatively strong home building group HD operates as a home improvement retailer, selling a wide range of building materials, home improvement products, and lawn and garden products.

With a current Historical Volatility of 13.04 and with an Implied Volatility Mean Index of 20.93, up from 20.86 last week, our forecast is for 30 by the earnings release date on May 18, 2010. Once again, we suggest using a volatility reversal plan such as this one.

Buy Jun 37 Straddle

This is also a rising volatility position so our concern is a failure of implied volatility to rise. The earnings report is scheduled 3 days before the May options expiration so we will be concerned if implied volatility has not increased enough to proceed with the second reversal part of the trade plan.

I'll definitely be watching these two trades and what level of success is possible. This is an options strategy that I don't use, but would be welcome into my trading arsenal.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/