DIS – how I pick and setup an earnings trade

Yesterday, just before the close, I put on a trade in DIS.  They are set to report earnings today after market close. I put on a ratio diagonal spread.  I am going to walk you through my thought logic in picking this trade.

My first stop is the Live Vol Pro (www.livevol.com) software Calendar tab. I look at all the earnings for the desired date.  I then pick liquid names that are usually trading above $25 per share.  (click any picture to enlarge)

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Then I look at these symbols in the Skew tab looking for horizontal and vertical skew. 

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Next, I move to the Charts tab and look at the six month plot of 30 and 60 day implied volatility.

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And finally, I look at the previous earnings periods moves and responses of IV and the prices of the front and back month straddles in the “Earnings and Divis” tab to get a feel for how this underlying responds to earnings historically.

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In the case of DIS I see that there are both horizontal and vertical skew.  I see that both 30 and 60 day IV are not that elevated compared to previous six months IV and especially not high compared to historic earnings announcements.

Putting all this together I will then pick which trade to put on.  I almost always use term structure when trading earnings, selling high IV near term options and hedging with back month options.  When you trade calendars and diagonals one of your big risks is IV collapse of your long options along with your short options.  In this case, I don’t see much Vol crush happening to my long back month options as they are low relative to historic IV.  With only 11 days remaining in the front month Aug options, they will experience some Vol crush as IV goes to zero at expiration.

So, at this point I look at the skew tab and get an idea of where I want to be short and long.  I want to sell overpriced lower strike Aug options and buy higher strike Sep options taking advantage of Horizontal (month to month) skew and Vertical (strike to strike) skew. 

In this case I changed my strategy slightly by buying a higher strike than I sold but I am  still buying lower IV than selling. I put on half of a position yesterday and will put on the other half today.  If the underlying moves in the desired direction I’m happy as I have a small win already, and if the underlying moves in the opposite direction, I’m happy as I get a better fill price for my second half.  It’s a win-win situation, rare in trading.  Here’s the trade:

(Half position) Long twenty Sep $35 puts, Short ten Aug $38 puts for  a credit of $0.56 per 1:2 spread.

The P&L chart looks like this:

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As you can see, I’m looking for a significant move in DIS, preferably to the downside.  Historically DIS gaps after earnings enough to move past my breakeven points, especially when it’s to the downside which is where my biggest profits will come.  Using the Thinkorswim analyze tab I model this with dropping the Aug IV by 5% and Sep by 2%.  This puts my breakeven points $33.78 and $36.20. Dis closed at $35.16 so there’s not that much of move needed.  This is a defined risk trade.  My max loss would never occur because I’m not going to hold my Sep options until they expire, but the max loss would be around $2,400 if the Sep options IV went to zero which will never happen.  With my above prediction of IV the max loss, if Dis moves nowhere, is around $300-$500.

Double these numbers for when I put on the remaining half today.

Plotting the breakeven points against the daily chart in Thinkorswim looks like this:

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Exit strategy: Since this is a defined low risk trade I’m not in any hurry to get out, but it is a negative theta trade so time is working against me.  If there is a gap opening I’ll take my profit of at least half the position immediately and then watch the remaining for a big move in Dis after earnings. 

As always, I’ll keep you posted.

Comments are encouraged and appreciated.  Thanks for reading!  Lawrence

One Response to DIS – how I pick and setup an earnings trade

  1. Great post. Thanks for sharing your trade set up. I am interested in the specifics of your analysis of the skew. At some point, on this or another, maybe you could go into some more detail about what you are looking at when examining skew. Potential pitfalls? Classic term structures? What types of things stand out to you? etc. Thanks!

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