Thursday, June 18, 2009

Off the RIMM

We got RIMM earnings on deck tonight, so let's take a look at current volatility levels and see what the options board is pricing in. It's always interesting to see a company report earnings the day before options expiration, as the front month options (with 1 day left to expiration) give us a clear glimpse into how much the stock is expected to gap after the earnings announcement. It also provides some interesting 1 day option plays for those that have a strong bias as to whether or not implied volatility is cheap or expensive.

RIMM's historical volatility has dropped significantly over the last few months, which is altogether not surprising given the overall market has quieted down drastically. RIMM's 30 day HV currently sits at 44%, while 10 day HV is sitting at 35%. In anticipation of tonight's earnings announcement, RIMM's Implied volatility has risen to 72%- an obvious premium to current levels of realized volatility.

The $64K question is whether or not IV is too high or too low. Are the options overpricing the gap RIMM will experience tomorrow or underpricing it?

RIMM is currently trading at $76.75. We can look at a June strangle to get a read on how big of a move RIMM needs to make for the options to be fairly priced. The 75-80 June strangle (long 75 put, long 80 call) currently costs $5.75. Those buying the strangle are betting that RIMM will gap up to at least $85.75 or gap down to at least $69.25. That's an 11% upside move and a 10% downside move. Take a look at the risk graph.

If I thought RIMM was going to gap more than 11%, I may look at purchasing the strangle. What if I believe RIMM will not gap more than 11%? Well, I could look to enter a short strangle or perhaps an Iron Condor. Because condors have limited risk, I personally prefer them to short strangles. Let's take a look at 2 potential iron condors I could place on RIMM.

Iron Condor #1: 65-70 put spread plus 85-90 call spread
The 70-65 put spread is trading for $.85
The 85-90 call spread is trading for $.85
The net credit for the condor is $1.70
Max Risk = $3.30
ROI = 51%
Probability of Profit = 55%

Iron Condor #2: 65-60 put spread plus 90-95 call spread
The 65-60 put spread is trading for $.28
The 90-95 call spread is trading for $.28
The net credit for the condor is $.56
Max Risk = $4.44
ROI = 12%
Probability of Profit = 81%

Due to the lower deltas of the short call & put (90 & 65) in the second iron condor, the probability of profit is much higher (81% vs. 55%). The trade-off is we only receive $.56 total credit, which maybe insufficient for most traders.

I don't really have a strong bias one way or the other as to whether RIMM vol is cheap or expensive, but merely offer these option strategies up as examples for how to get long what you think may be cheap vol or short expensive vol into an earnings announcement.

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1option said...

Thanks for the great post! Very informative. I agree that the likelyhood of a 10% move either way does not seem like so one of the two condors you suggested could be an awesome play here.

Sing Lee said...

Thanks for the post