The Incredible Effect of Falling Options Volatility After Earnings

During earnings season, day and swing traders often find their best profit opportunities each quarter, but very few traders understand the opportunities that are available by using options spreads to take advantage of the big moves that surround a stock after it’s quarterly earnings report is released. In this video, we’ll show you an incredible example of an options spread trade that could have been taken before TSLA released its earnings report recently and we’ll explain why this technique is so powerful.

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every quarter day and swing traders get
their best opportunities to make money
during earnings season when stocks
traditionally make
outsized moves in reaction to the
earnings releases of the stocks they
follow
i’m seth freuberg the head trader of smb
capitals options trading desk here in
manhattan and the traders on our desk
are
constantly looking for unique ways of
profiting from the volatility that takes
place
after stocks release their earnings
reports and how the options market
takes those anticipated moves into
consideration
if you’re looking for an incredible
example of just how dramatic the profit
opportunities can get by using option
spreads during earnings season
then stick around because you’re not
going to believe what happens in this
example that i’m about to demonstrate
hi i’m seth freyberg and i’m the head
trader of smb capitals options trading
desk
smb capital is a proprietary trading
firm located in midtown manhattan
and we provide capital for options and
equity traders from all over the world
trading both remotely
and in our offices here in new york city
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world they’re really very valuable
just about the craziest trading stock
over this past year has been tesla
and tesla is a stock that’s constantly
making large moves
so it should be no surprise that as the
stock was approaching its quarterly
earnings report in july
that the entire financial world was
expecting tesla
to have a huge reaction to its earnings
report now when that happens
then that same anticipation of a huge
move right after the earnings report
is released gets translated into the
pricing of
options so let’s drill down to
understand this phenomenon
now most of you probably know something
about options but but just for a quick
review and this will be fast
what’s known as a call option on a stock
entitles the buyer of that option to
purchase 100 shares of that stock at a
certain price called
the strike price of that option
regardless of what price
the stock is actually trading at what’s
called a put option on the other hand
entitles the buyer of that put
to sell 100 shares of the stock he owns
at the strike price of that put again
regardless
of what price the stock is trading the
buyer of the option pays what’s called a
premium to the seller of the option
because the seller of the option is
taking the risk
that the stock will go past the strike
price of the option
in which case the buyer can exercise his
option so in the case of a call
even if the stock has gone way above the
strike price of the call
the call buyer can exercise his right to
buy 100 shares
at the strike price in other words he’s
entitled to buy the shares
way below market he could flip them the
next minute and make a huge profit on
those shares in that case
or conversely on the put option even if
the market goes way below the strike
price of that put option the buyer of
that put option
has the right to sell his shares of that
stock at the strike price of the put
option that he’s bought
even if the stock price has gone way
below the strike price
of the put which of course saves him a
lot of money compared to whether he
didn’t own the put and he’s stuck
suffering a much larger loss on his
shares because
their price has gone way below where
they were trading before
but he had no protection against that
happening so all other things being
equal when a stock price goes
up a call option for that stock will go
up
because the right becomes naturally more
valuable to the buyer
and when a stock price goes down a put
option for that stock will go
up because that rate naturally becomes
more valuable to the buyer
so those are the basics of call and put
options
okay with that as background one of the
ways that options traders like to
measure
how much of a move the market is
expecting is by looking at the
options that have strike prices very
close to the market price of the stock
in question
so let’s go back to june 17th which is
more than a month before tesla’s
second quarter earnings are going to be
released and as you can see
tesla is trading at 991.80 having rally
back
from its mid-march lows of under 400
so tesla has more than doubled in three
months on top of which it blasted
through its all-time highs
which it had hit before the pandemic
struck
and so now let’s take a look at the 990
options on that day
on the options chain that is expiring 10
days from that day
on june 26 and as you can see the 990
strike
price is the closest to the market price
and as you can see the call of that
strike the at the money call
is priced at 37.97
whereas the at the money put is priced
at 37.32
which incidentally makes sense because
on volatile stocks pretty much anything
can happen and so
the market pro is pricing the risk of a
rally on the stock
at about the same price that is pricing
in a sell-off on that stock and so
if you add that up the total cost of
both the call
and the put it comes to 75.29 now
let’s move forward to eight days before
earnings
and as you can see tesla has rallied
again now almost
quadrupled its price from the depths of
the market crash all the way up to
1510 and the combined call and put
premium has now
skyrocketed from 75.29
one month earlier now it’s up to
291.70 that’s a huge price for those
options
and reflects dramatically how much risk
the seller of those calls
and the seller of those puts is taking
so when you have a situation as volatile
as this
some options traders form an opinion
from studying the market
and previous price moves off of earnings
for this stock
and similar stocks that the price built
into those options may be a little
higher than they need to be
and that the market is exaggerating the
potential reaction
to the earnings report and has gone
overboard with those premiums
there are options traders who carefully
study these things and have a sense of
whether these prices are higher
than they have to be and then they take
advantage of that over pricing by
selling the call
and the put at the money as the date of
earnings is fast approaching
so let’s say that a trader makes the
decision to do just that and go ahead
and sell the 1500 call and sell the 1500
put
and collect that 291 dollars in premium
well
for reasons that we can discuss on
another video about how brokers margin
retail options traders
you need an unacceptably high level of
capital in your account to simply
sell the call and sell to put it the
money on a stock this volatile
and so what most traders will do is to
buy a long call
and a long put further away from the
market price and in this case
the trader could have moved up to the
1900 call
400 points above the market and moved
down 400 points to the
1100 put and bought those as well now
this combination
a short at the money call and a short at
the money put
combined with a long call and a long put
both farther away from the money that
combination
is known as an iron butterfly to options
income traders
and it is a powerful trade to employ
before earnings
as you’re about to see i wanted to let
you know that there really are
sound viable long-term techniques for
trading options for income and in fact
we’re currently running
a two-hour free intensive workshop at
the moment where we’ll be teaching you
three of those strategies that real
professional options traders use
including
a really simple but incredibly effective
technique
that some of the greatest investors in
the world like warren buffett use
all the time plus an options trading
strategy that has a
statistical eighty percent probability
of profit month in and month out
plus an option strategy that you can
employ with a stock that you like where
you’ll make your target profit
whether the stock goes up goes nowhere
or even goes down a small percentage so
if those strategies would be of interest
to you then you should check out
the free options class that we’re
currently running just go ahead and
click the link that should be appearing
now
at the top right corner of your screen
that will open the free registration
page in a new window
so don’t worry you won’t lose this video
or you can just head on over to
optionsclass.com
to register for this free intensive
workshop it’s a rare opportunity
for retail traders and investors to
learn directly from wall street traders
but that’s exactly what you’ll be
getting
through this free online workshop so
click the link to sign up now and don’t
miss
it getting back to the iron butterfly
that we’ve constructed leading into
tesla’s earnings report
let’s first analyze the cash flow of the
transaction that we’ve entered into
so first of all we’ll account for the
short call at 1500 and as you can see
that was priced at
147.90 as we said but remember
that represents the the right to buy 100
shares of tesla
at 1500 so you have to multiply that by
100
to arrive at the total cash flow of 14
790
and you do the same for the price of the
put which
you see brings in 14 380 but remember
now we bought those protective calls and
puts
and those were a cost to us and so we
subtract the cost of those from the cash
flow
to arrive at a net cash flow number of
twenty two thousand
four thirty one and those flow right
into our account instantly after the
transaction
now because tesla is a high price stock
the options are also expensive
and for reasons that we can explain in a
video on margins
the total capital which is the maximum
risk on this trade
is 17 569 now
let’s move to the day before earnings
which is july 22nd and you can see
that tesla has now rallied to 1592 in
anticipation
of a solid earnings report so that
afternoon
earnings were announced and let’s take a
look at what happens to the trade
the next day well the stock is actually
selling off after the earnings report
and mid afternoon it happened to sell
right back down to 1500
which happens to be convenient because
we can now compare
the value of the trade the day after
earnings from its value on the day we
entered
into it eight days earlier when the
premiums were much higher in
anticipation
of an unknown reaction to an earnings
report
and so as you can see the short call and
the short put have dramatically shrunken
in value
and if you add up their current value it
comes to 66.15
down from the 290 170 value
that we received for selling those two
originally
now and this is the crucial point of
this video you’re probably asking
why did those values drop so much
and the answer simple the earnings were
released and the market has now
spoken and it turns out that at this
moment the market’s valuing this stock
at exactly the same price as when we
enter the trade but there’s
one giant difference as far as the
options are concerned
and that is the uncertainty is now over
the market had a negative reaction to
the earnings report
but not terribly negative the stock
dropped about 90 points
but the market was picturing a much
larger reaction than that
which is why it charged more than 140
dollars per share for both the call
and the put when we first enter the
trade but now
that the uncertainty is over and the
market has played out
a fair amount of its reaction to the
earning report the options traders are
now more comfortable they don’t need to
price in some
massive move in the future because the
big marketing the big market moving
event the earnings report
is now behind us so we can drop the
value of the options back to
more normal levels remember we showed
you the cost of the tesla options in
june
and the at the money call and the at the
money put were
combined cost of 75 whereas now after
earnings those same at the money options
have dropped to around 66.
in other words they’ve returned to a
more normal level
whereas 10 days before earnings during
the period of uncertainty
about what the earnings report will
bring in the cost of those two at the
money options was closer to
300 and so that phenomenon that dropping
of options pricing right after earnings
is what options traders call the vol
crush
short for volatility crush and it can
work out very
well and very powerfully for you in
certain cases
so at this point we will almost
certainly close the trade as its very
good fortune that the market has
returned
to the location of the at the money
calls and the at the money puts right
after earnings
in addition to which we’re two days out
from expiration so now let’s take a look
at what it would cost us to close this
trade and wrap this up
so basically to close an options trade
you simply reverse each position so if
you’re short of position
you buy that option and if you’re long a
position you
sell that option and so as you can see
when you combine the much more
reasonable cost
of buying back those short options and
receiving that very small amount
for those protective long options which
had almost no value now that they’re 400
points away from the stock price with
two days to go before the options expire
combining all of that you end up with a
profit of over fifteen thousand dollars
and when you do the math again the
original capital requirement
of seventeen thousand five hundred sixty
nine dollars
that’s the denominator so that comes out
to a
90 return in eight days
so the major lesson that i’d like you to
learn from this video is the fact that
if a stock is acting
in an extreme way around earnings there
may be cases where the options market is
so spooked
that it charges insanely high prices for
exposing
the options near the market price to
what could be a very
large price move in those cases it may
make sense to sell those options
instead of buy them entering into a more
conservative
iron butterfly trade and on occasion
spectacular results could take place
like would have happened in this tesla
iron butterfly trade
options income traders are very familiar
with iron butterflies
and how advantageous they can be when
you’ve done your homework
about the movement of stocks around
earnings like professional options
traders do
now just to remind you as i said earlier
if you enjoyed this video
and learned something valuable from it
would like to learn the details of three
real world option strategies that
professional options traders
use all the time then you should check
out the free options class
that we’re currently running just go
ahead and click the link that should be
appearing now at the top right corner of
your screen
that will open the free registration
page in a new window so you won’t lose
this video
don’t worry or you can just head on over
to optionsclass.com
to register for this free intensive
workshop it really is a rare opportunity
for retail traders and investors to
learn directly from wall street traders
but that’s exactly what you’ll be
getting
through this free online workshop so
click the link to sign up now
and don’t miss it and please don’t
forget to click on the subscribe button
right now so you won’t miss free trading
videos that we’re posting constantly
on our channel to help you to improve
your game as an options trader

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