Uncle Theta’s been doing some experimenting. And in the latest, he figured out something that’s been happening for years. A drop in the option prices of TCS immediately after their results. There’s a big run up and boom, the option prices – the implied volatilities actually – drop dramatically after results.
Here’s the chart we got out of Snap. (Capitalmind calculates each stock’s Implied Volatility and you can chart it).
The spikes in the IV (lower panel) are an increase in expectation that TCS will move big time. We saw on Snap’s IV Table that TCS’ IV was at 94% of its annual range on a percentile basis. And no matter what, the IV would drop post results.
Technically a stock will move a lot on the day of results. In TCS’ case, it would be the day after results, as TCS announces results after market. (Only on 13 Oct 2015 was the result announced in market hours)
And indeed the stock does move – about 2.3% on average in the last 10 quarters or so. But a strange thing was: the market overprices the options in general. A straddle (the call+put at the same strike) would trade at a high value pre-results and drop immediately after. We add the prices of the call+put to get the straddle value. The table below shows you what happens if you *write* straddles the day of the result and buy it back the day after.
There is a risk. In October 2014, the stock fell over 8% and option writers lost money. Even then, there were opportunities within the day when an exit would have been easier at a better point.
We decided to do an experiemental trade – a high risk one – of writing options on TCS for results. We wrote a 2250 Put and a 2350 Call, to avoid the higher risk of a straddle. This is a 2250 strangle and we got in at about Rs. 68 a couple days before results. We understood that the IV would still go up till results and indeed the strangle went to Rs. 75 on Thursday (12th, the day of the results).
On Friday, after the results showed no surprise including N. Chandra’s elevation to Tata Sons’ Chief, the IV of TCS fell dramatically. The same strangle quoted at Rs. 41 at about 9:30 am on Friday, and we exited (bought them back).
The profit was about 27 points on a lot of 250. That’s about Rs. 6750 for a margin allocation of about Rs. 170,000. Assuming the sum at risk was much higher – 250,000 – that’s about 2.5% as a return in a very short time.
Result strangles are very risky because stocks can move a lot. There are important things to note:
• Is this stock and the options liquid? TCS options were liquid. But others are not, like JSW Steel. See the Snap Liquidity list.
• Is the IV very high in both absolute and relative terms? On Snap we show the IV percentile, IV Rank and absolute IV of each stock with options. If the IV is less than 20, don’t even bother. And for IVs for 25+, check if the stock generally has an IV of 25+. Only stocks with IV percentiles of 85% or higher make sense for results strangles.
• How much does the stock move on results? If a stock move is so high on results that it is even higher than options expect, then you should avoid the straddle or strangle write.
• Is there a reason for the stock to move big? Sometimes the market expects some blockbuster news for a particular result. This could derail a back-test also. In general, we don’t know what we don’t know, so it’s impossible to be aware before a big move. But there are times when it’s just better to avoid stocks that have massive one time moves. (We would avoid Biocon, for instance, as any small change in news can be a huge move in the stock).
You can also mitigate the risk by converting the straddle or strangle by “buying the wings”. This results in an Iron Condor or Iron Butterfly. A 2250-2350 strangle can be hedged by a 2150-2450 strangle BUY. This introduces a max-loss of about 40 points for a max gain of 60 points. But this will reduce your profit substantially. (For instance, this time the profit would only be about 12-13 points rather than 27, halving the return)
A wider Iron condor would be long the 2100 Put and the 2500 call. The risk here is of 90 point losses at the maximum for a 60 point gain (max). Your profit would fall by about 10% on this versus a naked short strangle.
But it does provide a higher risk mitigation potential.
Result based option writes can be very rewarding. There is a black swan potential – of one big move destroying what you’ve earned in the last few. However, calculated risk means you don’t risk so much that you go out of the game, and if averages play out, you just have to stay in and keep participating and it will come about in your favour. Uncle Theta finds the risk-reward attractive, with strangle writes, or iron condors strategically taken before certain stock results.