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 iron condor spreads on Cisco, Copa, and Sociedad Quimica using the paperMoney® feature on the thinkorswim® platform. I’m going to walk you through the nuances of my thought process, including why this could be a strategy used for trying to capture the volatility crush that often comes after an earnings report. Iron condors are made up of a couple of short options that drive the trade, and long options that can help protect it. I’m expecting the drop in implied volatility to help me turn a quick profit—basically selling options when they’re expensive before earnings and buying them back when they’ve hopefully lost value after. But this can only happen if the stock price stays between the two short strikes.
I’ll talk more about details like selecting expirations, choosing strikes, and exiting the trade in a minute.
Now, if I’ve already lost you because I’m using some advanced options terminology, you might want to check out some of our basic tutorials first. To get the most out of this video, you should have some experience with options. And, like all 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 three companies that were set to report earnings on the same day. All three had high options liquidity with plenty of open interest and volume to hopefully lead to good pricing on the options contracts.
Animation: An example graph of implied volatility rising ahead of an earnings call. After the call, the line shows a steep fall.
Narrator: The first was Cisco Systems (CSCO), which reported earnings on November 15 after the market close. Implied volatility tends to spike before an earnings announcement, especially in the front month options, due to uncertainty. After the announcement is absorbed by the market, implied volatility tends to go away in what’s called a volatility crush. My goal was to try to profit from the change in volatility by selling an iron condor for a credit and buying the spread back when it’s worth a lot less, pocketing the difference, after fees.
Animation: The thinkorswim papermoney platform appears on screen. The Trade tab is open.
Narrator: When I looked at the expirations on the Trade tab, I saw that the implied volatility for all contracts for the 17 NOV 23 expiration was 60.86%. This was about 24 percentage points above the next expiration at 36.55%, which signals that extrinsic value for these options was very high. After the announcement, that volatility should return to a normal range that's closer to the 24 NOV 23s.
Animation: A risk profile of an iron condor is displayed. Dotted horizontal lines show where the different strike prices line up on the profile.
Narrator: The next step was to select my strikes for the iron condor. It’s made up of four different strikes—a long and a short call and a long and a short put of the same expiration. Another way to think of it is that you have a vertical call spread and a vertical put spread at the same time. Because an iron condor is made up of four contracts, paying a fee for each contract in each leg of the strategy could be considerable. Consider these fees as you set up and close your trades.
I can earn max profit if the price of the stock stays in the upper flat area. This line is between the two short options. Profits decline and losses start if the price of the stock is below or above the short strike prices shown by this flat area. A large price move will put me not only outside of the flat area, but outside of the long strike prices, which is max loss.
Remember that the short options drive the trade because of the credit from the larger premiums. If implied volatility falls, the value of the premiums will shrink. So, if I buy back the options later, I’ll get to keep more of the initial credit.
Additionally, short options also benefit from time decay. Time decay may help me hang on to more of the cash received from the original credit from opening the trade. Of course, this only leads to a max gain if the underlying price stays between the short strikes.
So, once I’ve chosen my short options, it’s time to select the long options. The long legs of the trade are farther out of the money because they’re there to limit potential losses in case the trade goes badly. The further out of the money, the cheaper the options, but the higher the maximum potential loss.
Another important risk to understand is if the stock price closes between the long and short strike prices at expiration. If that happens, I'll likely be assigned on a short strike. If it's the call, I'll need to deliver 100 shares of stock, which would put me in an unanticipated short position. The long call won't help because it'll have expired worthless. That makes me subject to unlimited risk if the stock rallies. If the short put is assigned, then I may end up owning the shares, which could also fall in value.
I’ve talked a lot about selecting the strikes, so let me explain how I did it.
Animation: The 17 November 2023 expiration is highlighted on the options table. The screen zooms in on the implied volatility data for that expiration.
Narrator: 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 $2.40. 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 short call at least $2.40 higher than the current price and the short put would be at least $2.40 lower.
Animation: The market maker move is highlighted on the platform and is designated with three Ms and a dollar figure.
Narrator: However, there are two other estimates of a price move traders often 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 like implied volatility to estimate how much the market expects the price will move after the announcement. In this case, it was forecasting $2.33 in either direction.
Animation: The options chain layout is changed by clicking the Spread list and selecting Straddle. The bid and ask prices for the 53/53 straddle are highlighted.
Narrator: The second tool is the at-the-money straddle for the front month. I saw this by changing the Spread to Straddle. The 53-straddle had a mid price, which is the halfway point between the bid and ask, of about $2.42.
So, these tools gave me a range of $2.33 to $2.42. With Cisco now trading at $53, I thought about putting the short call strike at 55.5 or higher and the short put strike at 50.5 or lower.
However, I also wanted to look at the chart for some additional insight. The 90-day, one-hour chart for Cisco showed the stock was mostly moving sideways and implied volatility was near its high for the period. Despite the rise in volatility over the last month, it moved down a little the previous week or so. Ideally, I would've liked a spike in implied volatility in anticipation of earnings the next day.
Looking at the stock price, I could see some price consolidation between $55 and $51. I drew some lines to mark the area, which were in line with the other tools.
So, I started the iron condor trade using the Trade tab, changing the Spread layout to iron condor. Then I selected an iron condor that was close to the strikes I wanted—knowing I would finish setting the strikes in the Analyze tab. Then I changed the number of spreads to just one.
Animation: The platform is changed to the Analyze tab and the Risk Profile subtab shows the potential gains and losses. Lines appear on screen highlighting the strike prices.
Narrator: On the Analyze tab, I set the call strikes at 55 and 56 and the put strikes at 50 and 49. Both levels were near my consolidation lines and outside the Trade tab tools averages. My hope was that the stock would stay between these levels.
So, the theoretical max profit is about $35, which I'd get if the stock price stays between the short strikes at $50 and $55. But I do have some extra space between the strikes to eke out some smaller gains, as well as break-even points too. These spaces slightly increase my likelihood of getting some profit.
The theoretical max loss is about $65, which occurs if the stock price falls below $49 or goes above $56. When trading an iron condor, I'm weighing the reward, the risk, and the probability of success. Currently, I’m risking more than the potential reward. However, the price can rise or fall $3 in either direction and I could still make some profit, which I believe is a pretty good probability of success. Every trader must determine what numbers they’re most comfortable with.
I went ahead and placed the trade.
Animation: The platform moves back to the Trade tab showing Copa Holdings.
Narrator: The next stock was Copa Holdings (CPA). It reported earnings the same day as Cisco.
Animation: The 17 November 2023 expiration is highlighted on the options table. The screen zooms in on the implied volatility data for that expiration. The market maker moves is highlighted and the platform’s layout is changed to Straddle.
Narrator: The 17 NOV 23 implied volatility was at 89.4% and was forecasting a move of about $6. The Market Maker Move was a little lower at $5.78. And the at-the-money straddle mid price was $5.65.
The price of the stock when I was looking at this trade was $91, so I could've placed the short call strike at $97 or above and the put strike at $85 or below.
Animation: The Charts tab is opened.
Narrator: Next, I analyzed the chart for Copa to see the support and resistance areas. Implied volatility was higher compared to historical levels, but off its highs. I’d typically prefer to see it spiking higher, but I felt that there was enough room for the trade to work.
I drew a line around $96, which was tighter than the other tools indicated. The other line was at $76, which was well below the other tools.
Moving over to the Analyze tab, I could see that unlike Cisco, which had more strikes to choose from, Copa had strikes at $5 increments. So, this iron condor ended up a bit wider with the call strikes at 100 and 105, and the put strikes at 80 and 75.
The theoretical max gain was about $35, which could be achieved if the stock’s price stayed between $80 and $100. The theoretical max loss was about $450 and occurred if the stock’s price fell below $75 or spiked above $105. The risk to reward is quite large, but I do have a range of $20 for the stock to stay within, so the probability of success is relatively high.
I went ahead and entered the order.
Animation: The platform moves back to the Trade tab showing Sociedad Quimica.
Narrator: The final trade was Sociedad Quimica (SQM), which also was reporting earnings on the 15th.
Animation: The 17 November 2023 expiration is highlighted on the options table. The screen zooms in on the implied volatility data for that expiration. The market maker moves is highlighted and the platform’s layout is changed to Straddle.
Narrator: The 17 NOV 23 expiration showed implied volatility at 96.8%, with an estimated move of $3.71. The Market Maker Move estimated the move at $3.29. And the at-the-money straddle mid price was at $3.65.
So, with the stock near $51.40, the short call could’ve been around $55 and the short put near $47.50.
Animation: The Charts tab is opened.
Narrator: I compared this to the chart, where the implied volatility was high without a big pullback like the other two stocks. I drew lines near $56 and $45, which was wider than the Trade tab tools.
Moving to the Analyze tab, I set the call spread to 55 and 57.5. The put spread was at 47.5 and 45. This gave me a potential max gain of $65 if the stock stayed between $47.50 and $55, and a potential max loss of $180 if the stock fell below $45 or shot up past $57.50.
Because these were very short-term trades, my only planned exit was to close them after the earnings announcements—remember, the lower the closing premium the better. If the value goes higher, then I’d have to pay more money to close the trades for a loss. I wouldn’t want to let them expire because the short options may be assigned, leaving me owning or shorting 100 shares of the stock that I may not want.
And we’re back. All three stocks reported earnings after yesterday’s close. The Monitor tab shows that I'm down on two of the three trades. Let’s break down what happened.
First is Copa. It had a profit of $20.50. From the Analyze tab I can see that the stock price stayed between the strike prices. The space between the pink and the blue risk profiles shows that there’s still some extrinsic value that could melt throughout the day, which would make the trade more profitable.
Next, I'll look at the chart. The stock price has moved higher and implied volatility has fallen. In this case, I was able to capture that implied volatility crush.
So, this trade went pretty well, but I need to decide when to close it. The options don’t expire until tomorrow, so I could wait one more day and use time decay to get a little more out of it. The tradeoff is 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.
It's a risk I don't think is worth taking, so I'll close the position.
Animation: The platform is changed to the Monitor tab.
Narrator: The next on the list is Cisco with a loss of $64.50. I'll take it to the Analyze tab too.
The price of the stock has fallen into max loss range. Notice that the pink risk profile is above the blue one down here. This indicates that time value is now working against me. So, opposite of Copa, I don’t want to let that last little bit of extrinsic value melt away when I can salvage some cash from it.
I could hold on to the trade and hope the stock will bounce back. The chart of the stock shows the price has fallen and so did implied volatility, but the price offset the gains from the volatility crush. It’s hard to know what the stock’s price is going to do next, so I’ll enter the closing order.
Animation: The platform is changed to the Monitor tab.
Narrator: Finally, there’s Sociedad Quimica. When I first logged in, it showed a small loss of $2.50. However, a minute ago it showed a gain of $2.50. Now, it’s at $0.
The Risk Profile shows that stock price is below the max gain but still above the break-even point. So, if I was to wait, assuming the stock price didn’t move, I could possibly walk away with a small gain—about $50 if all extrinsic value had melted away and not accounting for commissions or fees.
The chart for SQM shows that the stock has fallen but implied volatility may not have seen the entire volatility crush yet. So, once again, I could try to hang on to the position and monitor it to see if time decay and falling volatility could make the trade more profitable, but when it comes to managing trades, you have to weigh the amount of potential gain to the time spent monitoring it and the risk of it turning into a loss. In this case, I don’t think the small potential premium is worth it.
On screen text: Tradeoffs.
Narrator: So, what are the major takeaways? The first is make sure you understand the tradeoffs. For example, I just mentioned how important it is to consider how much time to spend monitoring a trade versus the potential return. Similarly, I've got to weigh the ability to eke out a little more profit compared to the increased gamma risk. Another example is selecting strikes that increase the potential return versus a smaller probability of success. Often, we think of these decisions in terms of right or wrong or winning or losing, but we’re just weighing the tradeoffs.
On screen text: Gamma risk.
Narrator: Another takeaway is to be aware of the power of gamma risk. Once much of the extrinsic value is gone, the options premium becomes very sensitive to the underlying price. In the case of Cisco, I was flirting with max loss because of how far the stock price moved.
On screen text: Plan.
Narrator: Third, have a plan for if a trade doesn’t go your way. Sometimes the trades just don’t work out. As helpful as all the tools were, Cisco fell more than projected. So, know what you’re going to do when you’re in those situations. Many traders close the trade and salvage what they can. Others like to let it go and hope for the best.
Trading around earnings is always risky because it’s a very emotional time for investors and you can’t predict the future. Try to put the probabilities in your favor, but also have a plan for when the market surprises 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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