Tuesday, July 7, 2009

Viewer Mail

I received an interesting question in regards to playing earnings announcements with iron condors or short strangles. The gist of the question was as follows

“When a company has an earnings announcement close to options expiration, do you use front month options in constructing a trade or do you use two month options?”

The answer is it depends. There are certain trade-offs to using front month vs. second month options.

One of the biggest factors influencing my decision is whether or not there is sufficient premium in front month options to make the trade feasible. In the case of RIMM, earnings came out the day before options expiration presenting an interesting one day play on front month options. Due to the high implied volatility in RIMM options, one day OTM options still possessed a surprising amount of value. As such, there was definitely enough rope in constructing a front month strangle or condor.

Tomorrow morning FDO (Family Dollar Stores) reports earnings. FDO closed today at $27.75- A glance at the options chain shows a front month strangle (short Jul 25 put + short Jul 30 call) is trading at $.55 net credit. The individual bid-ask spread of the trade is shown below.

Jul 25 Put .20 x .30

Jul 30 Call .30 x .35

As you can see, the front month short strangle provides insufficient credit. To me, the reward is simply not worth the risk. With the front month out of the equation, I would then look at two month options to see what’s available. On a side note - because FDO is a cheaper stock with fewer strikes to choose from, we aren’t really presented with much flexibility in putting on a front month trade (short strangle or condor). This is why I prefer to play these types of trades on higher price stocks or those that at least provide more strikes to choose from. The two month (Aug) strangle definitely provides adequate credit ($1.45) to justify doing the trade.

Aug 25 Put .60 x .70

Aug 30 Call .75 x .85

So, the first factor to consider in choosing months is the net credit provided. The next factor would be whether I’m comfortable with the range. Although the Aug short strangle provides enough credit to make the trade feasible, I personally wouldn’t be comfortable with the range. With the stock sitting at $27.75, either strike is only 8% away. I’d prefer a wider range especially given that we have about 6 weeks to expiration. Furthermore, the Aug 30 call has a delta of .33 and the Aug 25 put has a delta of .22. That puts my probability of profit at 45% (1 - .33 - .22), which certainly doesn’t excite me.

Now just because FDO front month options weren’t ripe with opportunity doesn’t mean you won’t find other trades that can use front month options. When you do it’s important to consider the greek differences between front month options vs. longer dated ones.

Front Month: Higher Theta, Higher Gamma, Lower Vega

Second Month (or longer): Lower Theta, Lower Gamma, Higher Vega

Given the differences listed, one must ask themselves which scenario they prefer. Second month options lessen ones exposure to gamma and increase their sensitivity to volatility crush (higher vega). However, they also provide a lower rate of time decay. Conversely, front month options increase ones exposure to gamma and somewhat lessens ones exposure to volatility crush (lower vega). But, do offer a higher rate of time decay.

In the end you must make the call.

I occasionally do intraday updates on Twitter with my thoughts on the markets or trades I’ve mentioned. If you’re not already following me on Twitter, you can do so here.

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