Market Overview

Binary Events And Volatility

Binary Events And Volatility

A trader facing a binary event -- such as an earnings date on a stock they are interested in, or FDA approval on a biotech stock -- may want to shy away from that event.  

Coupled with short-term Implied Volatility (IV) a trader may still be able to make a successful trade and have the results next morning.  Anyone buying options, calls or puts may see a particular stock move in their favor and still realize a loss -- as the IV is pulled out of those option premiums, the event is over and the news is out. IV is sucked out of the premiums like air out of a balloon.

So how can a trader capitalize on this situation? One way is to sell an iron condor in the front month or weekly option closest to expiration. Generally this is where IV is the highest, as the back-end month volatility settles down.

Related: A Simple Options Technique To Quell Market Worries

Let’s take a look at a recent earnings event for PetSmart (NASDAQ: PETM). Earnings were due out the morning of March 5th, and an iron condor could be established near the close the night before. The premium collected would have been around $0.52 for the iron condor trade:

March 2014   75/72.5 calls /62.5/62 puts for $0.52 credit

The IV at the time for the front month option was around 36 percent, high for this stock -- and we establish the strikes just outside the expected move for that month which was around $4.30.

The stock trading around $67.5 would then have an expected move calculated by adding and subtracting the $4.30 from the current which would give a range of:

67.5 +/- 4.30 = $71.80 to $63.20 expected range

You can see the strikes chosen above are just outside of those numbers. A trader would want the stock to trade inside this area,  and have the IV pulled out the next day, as the news event is over -- and buy back the iron condor for a small debit, to close a winning trade.

PETM earnings came in mixed, and the stock dropped to around 65.75 that morning -- well inside the range. It rallied later in the day, so it’s best to close first thing if possible.

The debit to buyback and close the trade would have been around $0.14, giving the trader:

$0.52 - $0.14 = $0.38 profit per contract.

The risk in this trade is the stock makes a big move and closes outside of its range. At that point you would be looking at a max loss on the position,and may have to use other measures to defend the trade. Keep this in mind when setting up the number of contracts you want to allocate to this position.

So the next time you face an earnings date on your stock, check the volatility and determine if you can get enough premium from the expected range, along with the IV crush, to setup a possible winning trade.

Tags: binary event binary options implied volatility

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