OAP 113: Long Straddle Earnings Option Strategy Backtest Results

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Often times when new traders go through their first couple earnings cycles and experience large moves in the underlying stock, it can feel almost natural to want to buy contracts via a long straddle earnings option strategy as opposed to selling options the way we teach here at Option Alpha. In today's show, I'll preview some of the new research we've been doing in the field of earnings trading and cover the results from three major companies we backtested; Apple, Chipotle, and Facebook. I think you'll find as you listen this episode that your confidence in sticking with these trades for many earnings cycles will go up dramatically.

Key Points from Today's Show:

  • Often times traders go through cycles where the stock makes incredibly big moves.
  • This encourages traders to buy long straddles heading into earnings; a long call/put at the money assuming that the stock will make a big move so that you can profit from it. 
  • However, it is not the case that the stock always consistently moves more than expected in the long term. The market is smart enough to overcorrect and implied volatility always overshoots the expected move, on average. 

Case Study 1: Apple

Did a long straddle every time earnings were present, all the way back to 2007 through now. This is a lot of earnings cycles and a lot of different information for Apple. Since then Apple has had a considerable move, which really challenges the validity of the strategies. We entered a long straddle at the money the day before earnings and took it off the next day. The stock was trading at $90; we bought the 90 put and the 90 call and closed it right after earnings were announced the next morning. 

Results: 

  • A long straddle in Apple for earnings only ended up winning 41.38% of the time. 
  • The average return over 10 years was -1.31%.
  • Over the long haul, a long option strategy results in a negative expected return, especially in a stock like Apple.
  • On the opposite end of this trade, if you had done the short straddle instead of buying options, you would have generated at least 60% of the time and expected a positive return. 
  • The straddle price before earnings, on average, was $15. 
  • The straddle price directly after earnings went down to about $7.95; not a great choice for long-option buyers.

Case Study 2: Facebook 

Entered the same long straddle position, entering right before earnings were announced and exiting again right after earnings were announced. This strategy only won 27% of the time, which is a huge miss for Facebook percentage-wise. These long options strategy simply do not perform as well as we think over time.

Results:

  • Had an annual return of 0.70%.
  • Only a couple of months ended up being the determining factor to keep it above board. 
  • If you missed a couple of those really big moves or if Facebook moved much higher than expected, then it would have resulted in a much more negative return.
  • On the counter side, if you had traded the short option strategy it would have worked out well, generating a positive expected return. 
  • On average, the market priced these straddles at about $5.62 before earnings.
  • After they announced earnings, the straddle pricing went down to $1.78. 
  • The key was that the crash in the volatility and the straddle pricing is really why this strategy was a big loser. 
  • However, this was a really good winner for option sellers.  
  • The average expected move in Facebook was $6.45 and the actual expected move on Facebook was $7.09.
  • Facebook out-performed on average. 
  • If you could remove the biggest outlier from 2013, then Facebook under-performs by $6.16.
  • More recently, Facebook has begun to consistently under-perform its expected moves.

Case Study 3: Chipotle

With Chipotle we used the same strategy as with Apple and Facebook, entering into a long straddle right before earnings and exiting it right after earnings. 

Results:

  • The overall win rate was 35.48%.
  • The average annual return was -2.59%, losing a significant amount of money in the trade. 
  • This again consistently led option sellers to be the beneficiaries of the earnings trade in Chipotle.
  • The average price of the straddle heading into the earnings event was 26.26%.
  • The stock went from the low 60's, all the way up to the 600's and back down to 400 - so the straddles are naturally going to be more pricey. 
  • On average the straddle price was 26.26 and after earnings the straddle price was 11.21, collapsing by more than half. 
  • There are huge moves in Chipotle, but they do not overshadow what actually happened in the long term.
  • Expected move in Chipotle was 7.01 and the actual move was 5.28 - the market vastly underperformed. 

Conclusion:

  • After big moves, we start to see expected moves and the stock expands and then smaller moves follow.
  • Generally speaking, when the stock outperforms the expectation the next couple of cycles end up being fairly quiet. 
  • If we do find ourselves in a quiet period where the stock has performed really well, we should be careful that it could surprise us shortly. 
  • Likewise, if the stock has been really volatile and has outperformed and moved more than expected in the last couple of cycles that means we could potentially be more aggressive as it might underperform heading forward.
  • Generally, there is also a lag time between the market catching up - earnings trades only happen four times a year. 
  • The market participants don't get a lot of data throughout the year to make changes to expectations and trading habits. 
  • If the stock has a huge move after earnings, more than expected, it might take a cycle or two for the options pricing to catch up and realize the new normal. 
  • At the end of the day, realizing how much these numbers gravitate towards what they should be on average, long-term is really powerful. 

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Option Trader Q&A

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from a listener, who asks:

I have a question about debit spreads and credit spreads: given a low implied volatility environment, let's say below the 50% percentile, would it be more profitable to trade debit spreads or credit spreads? Thanks a lot!

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
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  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.