Upbeat music plays throughout.
On-screen text: AMZN and AMD.
Narrator: Hey traders, on this episode of Tradecraft I'm going to show you how I set up and managed a couple of hypothetical, very short-term long call butterfly spreads on Amazon (AMZN) and Advanced Micro Devices (AMD) using the paperMoney® feature on the thinkorswim® platform. I'm going to walk you through the nuances of my thought process, including why this strategy could help capture the volatility crush that often comes after an earnings report.
Long call butterflies are created by buying an in-the-money call and selling two at-the-money calls, which reduces the cost of the long call. A final out-of-the-money call is purchased to hedge against a rally in the underlying stock. Butterflies work best when the underlying stock's price is expected to trade in a narrow range. So, my hope is that the stock price will remain relatively close to the short strikes, while extrinsic value drops due to the implied volatility crush that usually takes place after the earnings announcement. If all goes well, I'll sell the butterfly at a higher price.
I'll talk more about details like selecting expirations, choosing strikes, and exiting the trade in a minute.
You may have noticed that I'm using some advanced options terminology . To get the most out of this video, you should have some options knowledge and experience, so be sure to check out some of our basic tutorials first. And, like all of our videos, this is for educational purposes only and not individualized advice or a recommendation.
Okay, let me show you the trades I set up. I found two companies that were about to report earnings. Both had high options liquidity because they have plenty of volume, which can lead to good pricing on the options contracts. Neither company pays a dividend so that lowered my risk of early assignment on my short options.
The first was Amazon. The chart showed the price was pulling back a little while implied volatility was rising ahead of the announcement. This means that the options will be more expensive because they have higher extrinsic values. The contracts with the most extrinsic value are at the money, which is an important consideration when selling options. So, my short calls will lower the cost of the spread. Then, after the announcement, a volatility crush would hopefully result in those short calls melting and me selling the butterfly for more than I bought it.
When I looked at the expirations on the Trade tab, I saw that the implied volatility for all contracts for the 3 MAY 2024 expiration was 110%. This was about 44 percentage points above the next expiration at 66%. The difference signals that extrinsic value for these options was very high. After the announcement, I expected implied volatility to return to a normal level that's closer to the 10 May 2024 contracts.
The long strike prices are typically the same distance from the strike price of the short options. The lower long call is the driver of the trade. It's deep in the money, which makes it relatively expensive compared to the other calls. Selling the two short calls offsets much of the cost of the lower call. As the time value melts out of the short calls, my hope is that the value of the lower call remains high.
The higher long call acts as a hedge to the trade in case the underlying security rallies. If the price rises above the short strikes, the short calls will gain value, which would eventually overtake the value of the lower contract and result in a loss.
So, the trade will reach max profit if the underlying is at the middle strike prices at expiration. Max loss is generally the initial debit to create the position. It happens if the underlying moves below the strike price of the lower long call or above the strike price of the higher long call. The long butterfly has two break-even points, which are calculated as the lower strike price plus the debit or the higher strike minus the debit.
Another risk occurs if the underlying price is above the short strikes at expiration because they could be assigned. If the price is above the short strikes but below the upper long strike, you could be assigned both short contracts that would require you to deliver shares of the stock. In this example, that would be 200 shares. The lower long call option could be exercised to fulfill one contract of the short options, but you'll have to cover the other contract. Because in this scenario the upper call is out of the money, it would be more expensive to exercise it versus buying the shares outright. Of course, anytime you sell short options, you have some risk of early assignment regardless of where the stock price is.
Another thing to remember is that because a butterfly spread is made up of four contracts, paying a fee for each contract could be considerable. Weigh these fees as you set up and close your trades.
Long butterfly spreads are typically theta positive when the underlying stock price is in between the two break-even points. Time is working in favor of the position. However, if there's an extreme price move outside a break-even point, theta can become negative and time decay starts working against the position.
Of course, the strategy trait that I'm trying to exploit is negative vega. If implied volatility falls, the extrinsic value in the short options will dissipate quicker and the trade will be profitable sooner. But if volatility rises, extrinsic value will rise, and the trade will need a lot of help from time decay. Finally, it's unlikely that the price will hit right on the max gain, but my hope is that the volatility crush is big enough to make a decent return.
I've talked a lot about the strikes, so let me explain how I selected them.
First, I used the expiration's implied volatility to help me because it provides an idea of how much the market thinks the stock is going to rise or fall after the announcement. In this case, it's plus or minus $14.50. The tool doesn't give a direction, just an idea of how much of a move is reflected in the price of the options.
If I only used this tool, I would want my long calls at least $14.50 above and below the current price.
However, there are two other estimates of a price move traders can consider. First is the Market Maker Move, which is only available on the thinkorswim® platform. It shows up about a week ahead of an earnings announcement and uses several factors, including implied volatility, to estimate how much the market expects the price will move after the announcement. In this case, it was forecasting $13.83 in either direction.
The third tool is the at-the-money straddle for the front expiration. I saw this by changing the Spread to Straddle. The 180-straddle had a mid price, which is the halfway point between the bid and ask, of about $15.12.
So, these tools gave me a range of $13.83 to $15.12. With Amazon now trading near $179.50, I decided to put the long calls about $15 above and below the current price.
I bought the spread on the Trade tab by changing the Spread layout to Butterfly. Next, I selected the short strikes. Then I changed the number of spreads to one. Finally, I adjusted the long strikes to 165 and 195, in line with the Trade tab tools' averages.
On the Analyze tab, I went ahead and set the slices to breakeven and then I added a slice for the current price.
The theoretical max profit is about $1,100, which I'd get if the stock price hits right on $180 at expiration. The chances of that happening are small. However, the platform estimated that I had a 40% chance of the underlying stock price staying between the lower breakeven and the current price, and a 41% probability of it staying below the upper breakeven and the current price. Together, that's an estimated 82% likelihood of making some profit, not accounting for fees.
The theoretical max loss is the amount I paid to get in the trade, or $387 if my order filled at that point. I'll hit it if the stock price falls below $165 or rises above $195, though remember that the loss could always be worse if I was assigned early.
When trading a butterfly, I'm weighing the reward, the risk, and the probability of success. So, I was risking $387 to potentially make $1,100, but I had a more than 80% chance of making at least something.
However, remember, I was there for the implied volatility. I cleared out the breakeven slices to focus on the risk profiles. Then I clicked on the gear at the bottom so I could adjust the implied volatility of the strategies. You may remember that the difference between volatility for this expiration and the next was over 44 percentage points. So, I was curious what would happen if implied volatility dropped about that much. So, I ticked off one day to align with the earnings report and that caused the P/L Open, or the estimated profit and loss from the opening of the trade, to rise. Then I took off 40 percentage points of implied volatility. The P/L Open rose to $313 with the theoretical change in implied volatility and the day of time decay.
Next, I decided to see what would happen if the stock rallied to $188. The projected profit was $167. So, falling volatility should be profitable, but a change in the prices could greatly reduce my potential return.
I went ahead and placed the trade.
The other stock was Advanced Micro Devices or AMD. The stock had recently pulled back as well and was experiencing a rise in implied volatility ahead of earnings.
The 3 MAY 2024 implied volatility was at 115% and was forecasting a move of about $13.52. The Market Maker Move was a little lower at $12.43. And the at-the-money straddle mid price was $13.60.
These tools suggested the long strikes should be at least 13.50 higher and lower than the current price.
Next, I selected a butterfly spread that had the short strikes I wanted and reduced the number of contracts to one. Then I changed the lower strike to 146 and the higher one to 172.5. These weren't equidistant from the short strikes, but the higher strikes had fewer contracts to choose from and I could only trade what was given. It was close enough.
Moving over to the Analyze tab, the spread had a potential max gain of almost $1,000 if the stock is at $160 at expiration. The theoretical max loss was about $438 and occurred if the stock's price fell below $146. Notice how the max losses are different on the upside and downside because the strikes weren't equidistant. If the stock did have a big rally, my max loss was closer to $360, which would occur above $172.50. This is actually called a broken-wing butterfly. The platform is forecasting about an 80% chance of some gain if the stock fell between the two break-even points.
I went ahead and entered the order.
Because I was trying to capture the change in implied volatility, my only planned exit was to close the trades after the earnings announcements. Remember, I wanted the stocks to stay as close to their current price as possible and I wanted that implied volatility crush. I wasn't planning on holding the spread to expiration because I didn't want the continued risk of being assigned any shares. But remember, short options can be assigned at any time.
Here we are again. Both stocks have reported earnings. The Monitor tab showed that the Amazon butterfly was profitable, but the AMD trade had a loss. Let's break down what happened.
Amazon was showing a profit of $622.50 despite the stock rising more than 3% after the announcement. However, look at the big drop in implied volatility. The post-earnings volatility crush took place, which is a big driver behind the success. Additionally, implied volatility tends to go down when the stock price rises. So, the trade probably got a little more help from a positive market reaction.
Let's check out the trade in the Analyze tab. The stock price is surprisingly close to the max gain, which is adding to the success of the trade. The difference between the pink risk profile and the blue one is the remaining extrinsic value in the options. I could potentially hold on for two days and get a higher return as time value eats away the remaining premium but that only works if the stock price stays put.
With so much extrinsic value gone, I have higher gamma risk. This means that a price move in the underlying stock could result in a big move in the options contracts, which could turn my profit into a loss.
I don't know what the price is going to do over the next two days, and I got the volatility crush I was looking for, so I went ahead and closed the trade.
AMD has a loss of $269. Let's take a look at the chart and see how the market responded to its earnings announcement.
The stock fell nearly 8.5% after AMD reported earnings. Implied volatility also fell, which reflects that volatility crush I was counting on. However, the drop in the stock price resulted in a loss. The price fell below the break-even point, which changed the characteristics of the trade. I wanted it to now have higher implied volatility because it would keep the value of my trade higher, which appeared to happen. So, ironically, the volatility crush I was counting on may have been smaller, which may have helped reduce my losses. I'll demonstrate this in the Analyze tab.
Notice that the price of the stock has fallen to the lower long call strike. This means the trade is in max loss territory but there's still quite a bit of extrinsic value left in the trade. This is a good sign because my losses could be worse. The remaining extrinsic value is the difference between the pink risk profile and the blue one. So, I'm getting a bit of a buffer here.
However, because the pink line is over the blue line, it also indicates that the butterfly is now theta negative, which means time value is working against me. So, if I hung on to the trade, hoping the stock would rally, I risked that last bit of extrinsic value melting away when I could salvage some capital from it. If the stock continues to fall, closing now could've been the difference between a $269 loss and nearly a $500 max loss. Since I don't have a crystal ball, I decided to exit the trade.
What are the major takeaways?
First, know the relationship between implied volatility and the underlying security's price movement. Generally speaking, implied volatility rises when the stock price falls and falls when the stock price rises. We see how this relationship helped the profitability of the Amazon trade but may have helped limit losses on the AMD trade.
Of course, we know that implied volatility can still rise ahead of an earnings announcement even if the stock price is rising, so the relationship between option volatility and the underlying price isn't always opposite. But understanding the general relationship can inform the way you trade and the decisions you make.
Next, butterfly spreads can be more forgiving than you might think. While max gain is really hard to achieve, the probability of at least some gain was above 80% on each trade. Even though the price of AMD fell into max loss territory, my loss was smaller because of the remaining extrinsic value.
Finally, know how a strategy greeks can change under certain circumstances. A butterfly spread can go from theta positive to theta negative when the underlying price moves outside of break-even points. This means time decay goes from working with you, to working against you. Some people like to hold on and hope the price moves back into the range of profitability, but at that point time decay is against you. Others are happy to cut their losses, preserve as much capital as they can, and move on to the next trade.
Trading around earnings is always risky because it's difficult to know how the market will react to the announcement and no person or tool can predict the future. Try to put the probabilities in your favor, but understanding the subtleties and nuances of implied volatility can help you prepare for what the market throws at you.
Keep in mind that options trading involves unique risks and is not suitable for everyone and certain requirements must be met to trade options at Schwab. Check out our other videos to learn more.
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