Equity options straddles can be used to estimate the underlying move for events captured by the respective expiration. The classic Black-Scholes model requires five input variables: the strike price of an option, the current stock price, the time to expiration, the risk-free rate, and the volatility. However, an option’s implied volatility for an event can be reverse engineered from it’s price. For American style expiration options a Binomial model is used. Volatility unlike credit spreads or equity prices is mathematically proven to regress to the mean over time.

Earnings Estimates With Options Straddles

An option straddle consists of both the call and the put for the same strike in a given expiration. If the straddle is at the money, both options contain only extrinsic value. The price of an options straddle is often a reasonable tool for estimating the volatility of the underlying captured by it’s expiration. A key point to remember is volatility is movement, not direction. A long straddle buyer will benefit from the spread realizing a greater volatility than implied, and the converse is true for a straddle seller. However, the benefits of long gamma come at the price of daily theta decay. Equity straddles can also be used by investors to estimate the implied underlying move captured by an expiration. While not a panacea, it is often a very reasonable confluence of consensus, supply and demand.

For Example:

Assume equity XYZ is trading at $100 and has it’s next quarterly earning release on Thursday April 7th.

The corresponding XYZ 100 strike straddle expiring on Friday April 8th is trading at $7. Since this straddle’s expiration captures the next earnings release, and all things being equal quarterly earnings are often significant catalysts for equity moves, it’s reasonable to assume a 7% equity move is priced in for this earnings release. (This is simply a function of the ATM straddle price divided by the equity price.)

Let’s assume the historic realized move for XYZ equity over the past twelve quarters is 4%. Then this straddle at $7 is implying a significantly higher move for this expiration than the average of the past dozen realized expiration moves in XYZ. While anything can happen in a single event, over time the probabilities favor regression.

Equity Earnings Straddle Report Example

Source: Orats

Key Takeaways

Hedge Fund managers can use this metric in different ways.

-A volatility strategy might buy or sell the straddle based on their view.

-A convertible arbitrage strategy may sell additional options for premium or adjust their hedge ratio.

-An equity strategy could decide to implement a hedge, take profits or do equity replacement.

-A multi-platform risk manager might, calculate the average implied volatility of a portfolio equity component and order a risk reduction or implement a systemic portfolio overlay for an event such as a FED/ECB meeting.

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