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A Short Term Post-Earnings Trade

July 24, 2009 By Steven Place

This is a free trade, as it doesn't fit in our portfolio in terms of timeframe.

Well here's a little primer for the overall reasoning behind the trade.

Before earnings, there is a risk that the price action after the numbers release will be big, so people are willing to pay more and speculate on the move of the underlying via options. We often fade that implied volatility via iron condors and double calendars. Well, you can fade the implied volatility to the upside post earnings.

The morning after earnings, there is no longer a big "risk" in absolute terms, so extrinsic value comes out of the options. This is known as a volatility crush. And sometimes, the options can understate the volatility to come, which is when it makes sense to become an option buyer.

So one of my favorite plays is to buy straddles on a fairly liquid stock that has just released earnings and had a pretty large gap up or down-- this leads to a price inefficiency that we can exploit.

Ok, we actually had some bad numbers come out of earnings season, the two notables being AMZN and MSFT. We already have a couple iron condors setup on AMZN (that are working), but we didn't do anything with MSFT. So we'll play it after earnings.

So since the options board hasn't yet opened up, we can't get good prices-- but the idea is to buy an ATM straddle (buy call and buy put). This will be initially a delta neutral trade; it may have a slight directional bias depending whether the call or the put is in the money. The idea is that the stock will move faster than the time decay of your options, and the gamma in the options will increase your delta to the direction of the movement, and you make money provided we get a large move--either up or down.

Now here's the tricky part, and it comes back to trade management. Once the trade goes your way and it starts to turn back (either 22 or 25-ish) then it makes sense to use stock to delta hedge. Because of the options gamma, you can still make money if it goes your way, but if the stock swings back your original entry, then you lost the gains you made.

So you want to either buy or sell stock, depending on which way it went. So for example say MSFT continues to run to 22, which was a swing low. Well you're delta could be around -50, which means you're effectively short 50 shares of MSFT. Then you can go out and buy 50 shares of MSFT stock-- so if the stock finds support and begins to rally, you'll lose the gains from the straddle, but you'll be hedged via the stock. So you can trade around the position as the market oscillates.

This strategy is known as gamma scalping, and it's fun if you've got the patience to babysit the trade.

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