Information+Discussion-Trading The Earnings Cycle UsingStraddles-TeslaPlusOtherStocks

[MitchJi]

Hi,

Brief excerpts from the book "The Volatility Edge In Options Trading" are quoted below:
http://www.amazon.com/The-Volatility-Edge-Options-Trading/dp/0132354691
From Chapter 1 of the book, quoted for two reasons. Good examples of things to be careful of when selling calls, plus a clear example of IV and other indicators responding to insider trading:

Chapter 1 - Pages 14 and 15
The events of September 11 joined many other market draw downs by contradicting another important piece of conventional trading wisdom- the view that naked calls are riskier than naked puts. Nothing could be further from the truth; large negative price changes pose a greater risk to option sellers than large positive ones. The reason for the traditional view is that a stock can rise without limit but can only fall by an amount equal to its current price. For example, a $10 stock can suddenly fall to $0.00, making the $7.50 strike price put worth exactly $7.50 at expiration. The loss is limited. However, the same stock could theoretically rise to $50, taking the $12.50 strike price call $3750 into-the-money, a catastrophic event by any measure.

Practically speaking, both scenarios are highly unlikely. However, it is clear that a variety of events can cause investors to "panic" out of stocks, but very few news items have the capacity to drive an instantaneous catastrophic run-up. One in particular, the surprise announcement of a company acquisition at a price far above fair market value, can be very destructive to naked call sellers. One notable example was IBM's tender offer to purchase all outstanding shares of Lotus Development Corp. for $60 per share, nearly twice its trading price-in June 1995. Fortunately, there were clear indications that something was about to happen. The volume of $35 strike price calls more than tripled over three days from 672 to 2,028 contracts, the stock price climbed 10%, and volatility soared. Moreover, the $35 strike price call climbed from l/8 to 1 15/16 [almost 700%] during the three days preceding the announcement, and any investor short that call would certainly have closed the position. Finally, our trading strategy involves creating a statistical profile that compares the historical frequency of large price changes to the normal distribution. Lotus Development Corp. had a history of large price changes--often larger than 4 standard deviations from the mean. It would never have been a trading candidate for any uncovered positions. That Lotus might be a candidate for such an acquisition was one of the forces that caused its stock to behave poorly with regard to the standard model, Such stocks frequently respond to rumors with surprisingly large price movements. Conversely, we will see that it is entirely possible to identify stocks that are very unlikely to react in this way. Lotus notwithstanding, stocks rarely crash up, and indexes never do.

Chapter 7 - Trading The Earnings Cycle - Page 205
(two categories are mentioned, I focus mostly on the first - increasing volatility during the days that precede the ER)

Quarterly earnings create tremendous opportunities for option traders. For stocks that have a history of large earnings-associated price spikes, the market tends to overprice options by setting implied volatility too high. The distortion is especially large when an earnings release coincides with options expiration. For these stocks, implied volatility rises sharply to offset the rapid time decay of the final few days of the expiration cycle.

A second distortion occurs just after earnings are announced and volatility collapses back to an appropriate level. The rate of collapse
depends on the magnitude of the price spike. When the spike is much smaller than implied volatility would suggest, the collapse is very
rapid-sometimes just a few minutes long....

This chapter explores trading opportunities that arise from earnings driven price distortions. We will focus on two specific categories:
• Trades that benefit from increasing volatility during the days that precede an earnings release
• Trades that benefit from post-earnings volatility collapse

Chapter 7 - Trading The Earnings Cycle - Pages 222-223

Throughout this discussion we have purposely avoided measuring price changes in percentages. Analyzing price changes in standard deviations has allowed us to compare time frames of different lengths spanning different prices and volatilities. Any other analysis would have failed to provide a balanced view. The market is very efficient, and pricing anomalies are difficult to find. When one is found, it is important to analyze as much historical data and news as possible and to factor this information into every trade.

Generally speaking, naked short trades are dangerous, and most investors realize greater gains from well structured long positions. Some of this risk can be offset by keeping positions small enough that they can be offset with long or short stock. In the event of a very large earnings surprise, stock can be bought or sold during one of the extended-hours sessions. Large positions would make this approach impossible to implement

Summary
Option pricing distortions that accompany quarterly earnings announcements often provide excellent trading opportunities. Two major trends are evident: rising volatility during the days preceding an earnings announcement, and falling volatility immediately after earnings are released.

To take advantage of the first case, an investor might purchase a straddle during the final couple of weeks before earnings are announced and let rising volatility offset most of the time decay. At the implied volatility peak, just before earnings are released, the position would be closed. The position might be closed early if a large price spike generates substantial profit ahead of the volatility peak.

The second case involves opening a short position at the volatility peak, just before earnings are announced, and closing the position after the event, when implied volatility collapses. The rate of volatility collapse depends on the size of the distortion.

A perfectly reasonable investment strategy might be to avoid the everyday risks of the market, sit on the sidelines, and execute mathematically sound, carefully designed trades that take advantage of earnings-related price distortions. One advantage of this strategy is dramatically reduced market exposure. If long positions are the focus, market exposure is limited to a couple of weeks of time decay each quarter. Additionally, the risk is partly offset by rising volatility that tends to compensate for time decay when earnings and expiration occur in close proximity to each other.

Although short positions are riskier, it is often possible to limit the risk with a rational structure based on price change history. Such positions should be limited in size and, if a large price change occurs when earnings are announced, compensating trades can be placed in the before or after-market sessions.

I have three questions:
1. How simple or difficult is this to implement (sounds pretty simple)?

2. Any good candidates in addition to Tesla?

3. I would consider something like a straddle of (for example 10 calls and puts) and if it is profitable, and either IV is substantially higher (IV responding to insider trading?) keep a few of the corresponding options (paid for from the profits). Seem like a good idea?