Options are the tool of choice when it comes to hedging your equity or exchange traded fund positions. They also allow investors to enhance their positions through call and put writing. Options allow investors to benefit from the power of leverage, providing notional exposure to an underlying for a fraction of the cost of that underlying. All of these strategies are fairly straightforward and relatively easy to implement, involving the purchase or sale of a single, specific contract related to a held position.
Again, our answer is options. Examples of announcement events include earnings releases, lawsuit resolution, and legislation enactment. Both the Straddle and the Strangle trade were developed precisely for these opportunities. We are going to take a look at what it takes to identify, research, structure and implement these trades by taking a close look at the underlyings fundament history as well as develop a better understanding of just how important examining volatility can be in determining the viability of a trade.
Investors have to do their homework with regards to how their particular underlying reacts to certain news and make the determination as to whether or not capturing the expected price move is worth the premium involved. Because this position is established using OTM contracts, it is less expensive than the Straddle. As with the Straddle, investors have to do their homework with regards to how their particular underlying reacts to certain news.
All historical numbers presented or calculated are based on actual observed numbers and not theoretical values. Taking nothing for granted, you do some homework and research these same stats going back to Q2 of Further, when GOOG has had an earnings surprise greater than 2.
In addition to reviewing the fundamental aspects of this trade, you take a look at implied volatility for GOOG. You see that it has been declining ever since hitting a near term peak in early October.
GOOG closed at Based on the current spot price, the straddle trade has a breakeven of 7. Given the same assumptions as the Straddle position, you decide that you are going to set up a Strangle position 2. Based on this analysis, you decide to go with the Strangle. The earnings announcement happens at the market close on Thursday, October 13 th.
GOOG has moved from our entry point of You check your model and see that a 9. You look at the Call and it is now worth When a company reaches some decision point or announcement event, it is creating a certain amount of uncertainty.
The greater the uncertainty there is, the greater the opportunity for movement in the stock price. The market generally expresses uncertainty the only way it knows how, through volatility. Once that uncertainty is removed, volatility generally goes with it. When you went through the steps of researching and modeling this trade, you looked at historical post-earnings announcement price moves but did not research historical implied volatility changes for these same periods.
It turns out that over the same 25 periods, you observe that the average implied volatility for GOOG changes from In any option pricing model, the price of the underlying is important but what is equally if not more important is the volatility associated with that price level.
When considering implementing an option based strategy, it is not enough just to have an expectation of where the price of the underlying is going to be.
You must have an understanding and expectation of volatility as it relates to the underlying position. While you may not be completely comfortable with all the Greeks, it is imperative to become the best of friends with Vega. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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