Let's take a look at the risk profile for a straddle-strangle swap.
This will help us understand the possible outcomes of this strategy, and the probability
of profits or losses.
I'm going to create a risk profile using the Analyze tab in paperMoney®.
To begin, click the Analyze tab, and then click the Add Simulated Trades subtab.
We'll use Nike as an example because it has an earnings announcement in one day.
I'm going to build out the straddle-strangle swap following the rules from the sample investing
plan.
I'll start with the short options.
In order to capture the most inflated implied volatility and highest premiums possible,
we're looking for the weekly options that are closest to expiration.
It looks like these options that expire in the fourth week of December only have three
days left, so I'll use them in this example.
Now, to set up the short options, I need to sell the at-the-money call and put.
I'll do this by clicking the bid for each.
And, before I click the bid on the put, I'll hold down the control key combining these
options into a single trade.
Next are the long options.
For these I want less volatility inflation, so I'm looking for somewhere between two
and four weeks from expiration.
The third-week-in-January options are between three and four weeks away, so I'll use them.
.Selecting strikes for the long options requires a little more work on your part.
With these, you essentially need to pick a range of prices that you expect the stock
to stay within after the earnings announcement.
There are few ways you might forecast this.
You could come up with an estimate based on past price movement, or apply some technical
analysis.
You could even use a tool right here in paperMoney called the Market Maker Move indicator.
The Market Maker Move appears when an implied volatility differential is positive, meaning
the near-term expiration has greater volatility than the back month.
It's located up here, at the top right of the option chain.
Look for the icon featuring the three Ms. The Market Maker Move calculates the expected
price move based on the market volatility.
This number is the move that the price is expected to make between now and the expiration
of the front-month option.
In our example, it's currently $6.69.
We'll use this as the basis for our forecast.
So, we'll select options that are around $7 above and below the at-the-money strike.
Let's do the call first.
If the at-the-money strike is 130 and our Market Maker Move is 7, then I'll choose
the 137 call.
Now I'll buy the put.
For this, I'll take the at-the-money strike and subtract the Market Maker Move, which
means I'll buy the 123 put.
And finally, I'll adjust the quantity of our straddle-strangle swap down to just 1.
Now that we've selected the options for our trade, I'll click the Risk Profile subtab
to view its risk profile.
As you can see, the risk profile looks something like a triangle.
The green line shows the risk profile at expiration, and the purple line shows the risk profile
at the stock's current price.
You could increase the width of the triangle by selecting long strikes that are further
away from the at-the-money strike, but doing so increases the potential maximum loss.
Now, let's look at some key areas.
The peak of the triangle is the max profit.
Max loss can be found on both sides of the triangle and is only reached if the underlying
stock makes a big move in either direction.
The break-even points appear where the profile crosses the zero line.
However, if we were including commissions and fees, the space between these two points
would be a little narrower.
Now, focus on the purple risk profile line.
Watch how profitability rises when I advance time by one day.
However, time decay is not the main driver of this trade.
The real action is in implied volatility, so let's take a look at that.
To really see its effects, you have to treat the short and long options differently.
Because of the volatility skew, short-term options are more likely to have a larger drop
in implied volatility.
To make these adjustments, you need to access the volatility controls, which are found by
clicking the gear on the right, and then clicking More.
You can now adjust the implied volatility of the two expirations independently.
So, how should we adjust these?
Well, if we glance back to the "Add Simulated Trades" subtab, we can see that most of
the longer expirations' implied volatilities in our example are close to 34%.
The shorter expiration is higher, though, at 68%.
After a volatility crush, the implied volatility in the shorter expirations tends to move closer
to the implied volatilities of the longer expirations.
So, let's plan to reduce it down to 34%, which is a reduction of 34 percentage points.
Now, let's head back to the Risk Profile to make the adjustment.
Here, in the volatility adjustment, I'll subtract 34 percentage points.
Before I press Enter, note the current profit and loss: in this example, we're up $43.95.
Now, let's see what happens.
Did you see how the purple line jumped?
This reflects the crush in implied volatility.
Because of this crush, profits surged.
It's not uncommon for long options to experience falling implied volatility as well.
So let's reduce the implied volatility on these options to see how it might affect the
trade.
I'll reduce them by 2%.
As you can see, this drop reduced the trade's profitability.
This is why it's important to select a long option that's near "normal" levels of
implied volatility.
Of course, we still have a couple days of time value left.
By clicking those off, we'll help our profit a little bit.
But what about price?
Let's say the earnings report had some considerably bad news, and the stock dropped just below
the lower strike price to $120.
To see how this affected our trade, I'll type the new price into the Stock Price box,
and press Enter.
Now, the trade took a big hit.
Our current P/L shows a loss of $53.27.
As you can see up above, the shape of the risk profile didn't change.
What did change was that we're now $10 to the left of where we were before.
Stocks can make big moves on earnings announcements.
Therefore, for our trade to be successful, the price needs to stay within the range defined
by our strikes.
In summary, there are two factors you need to estimate with this trade: how far implied
volatility will drop and where you think the stock will end up after the event.
Performing practice trades in paperMoney can help you hone these skills.