How To Plan & Exit Volatility Positions For Earnings

Today we’ll be discussing positions for a long volatility strategy during earnings. We’ll review the specific positions we typically consider, discuss calibration methods, outline our targets, and focus especially on our exit strategies.

The goal is to prepare ourselves ahead of time so that we’re not caught off guard emotionally and can avoid reactive decisions.

We’ll use Morgan Stanley’s recent earnings as an example. We’ll delve into how these positions were set up, how they performed, and how we managed their calibration and exits.

Although this is a long volatility example, the same process can be applied to short volatility. Let’s dive right in and start by reviewing some of the signals indicating why Morgan Stanley was a strong candidate for long volatility strategies.

Long volatility, in essence, involves betting that the actual stock movement on the day following earnings release will exceed the movement implied by the market.

This strategy isn’t just directional; it encompasses non-directional positions involving both call and put options. The goal is to identify positions where actual volatility surpasses what’s priced in.

Why MS Was a Good Long Volatility Candidate

To assess this, we compared the current implied volatility (before earnings) against historical earnings moves.

Our analysis, using the Moves Analyzer on the EarningsWatcher platform, revealed a recap of past earnings moves that caught our interest. Specifically, we’re focusing on the central column of data excluding the most recent earnings.

Looking at previous earnings releases, we observed substantial movements: -5.5%, 8.6%, and 7.2%. This pattern suggests a generally volatile stock, with the smallest move over the last two years being 1.5%.

Prior to the recent earnings, the implied move for Morgan Stanley was approximately +4%.

These historical trends indicate potentially undervalued volatility, making the setup favorable for employing long volatility strategies with Morgan Stanley.

In the histogram, we have a graph illustrating the distribution of moves observed in this column. The x-axis represents the value of the move, while the y-axis shows its frequency or count.

Essentially, this graph reveals the most common moves based on their frequency.

We have plotted the ±4% threshold that is currently priced in. Notably, this threshold encompasses many of the frequent moves. Over the last decade, the most common move, as seen here, is around ±1%.

However, what catches our attention are the outliers — instances where the distribution deviates significantly.

As you can observe, there are notable occurrences beyond the ±4% threshold, suggesting that the implied move might be undervalued.

Upon analysing the average moves and other statistics from past occurrences, it appears that exceeding the ±4% threshold is quite likely.

The strategy here is to establish positions that offer a favorable risk-reward ratio, taking advantage of this potentially undervalued setup.

Before the Morgan Stanley earnings, we initiated and calibrated positions based on this analysis.

Classic Closest Expiration Straddle

The classic approach to the long volatility strategy, as you know, involves what’s called a straddle position.

In this case, we’re looking at the closest expiration straddle using a simulator from the EarningsWatcher platform, specifically designed to factor in IV Crush during earnings.

This straddle involves buying an 87 strike call and an 87 strike put, priced around $4.1 per contract, close to the 15th, just before Morgan Stanley’s earnings report on the 16th.

The current IV is at 50.4%, expected to drop to 31% after earnings.

The crucial aspect to consider with this straddle is the breakeven point, calculated at around ±4.2%.

This represents the expected move due to IV Crush and theta decay.

Looking at historical data, we anticipate a possible range of 0% (worst case) to around 7–8% (favorable), which helps us set realistic expectations for the earnings outcome.

Using these insights, we can establish targets for our position.

By simulating various stock movement scenarios, from 0% to +8%, we can predict how the straddle will perform.

For instance, with a 3.6% move (as shown in the simulation), our loss would decrease to 10% from a potential 30% in the worst-case scenario.

Ultimately, this position offers potential profits of up to 50% in the best-case scenario (+8% move) but could incur losses of up to 30% in a no-move scenario.

These figures are crucial considerations when deciding whether to enter such a position.

Lowering Max Loss: Further Expiration Straddle

To achieve lower risk, we can adjust our strategy accordingly.

For instance, opting for a more conservative and less risky position, such as a straddle with a longer expiration — like May 17th instead of April 19th — results in a slightly higher break-even point.

This increase in break-even is an expected trade-off when optimizing risk versus reward.

The cost of this position is higher at $6 per contract, but it reduces our maximum loss, altering our risk profile.

With this adjustment, our target range now shifts to approximately -20% to +40% (for 0% and ±8% move as before).

If the initial positions are not comfortable, there are methods to enhance risk management.

To further minimise risk, strategies like an inverse condor can be employed, allowing for even lower risk targets, suitable for those seeking minimal risk exposure.

Risky Strangle

Another approach involves embracing higher risk with the aim of achieving substantial returns, even if it means accepting a larger potential loss.

Here we’re looking at a strangle position with the closest expiration.

The strike prices are out of the money, making this position riskier.

The cost is significantly lower at just 86 cents per contract, compared to the $4 to $5 range we’ve seen earlier.

The breakeven point is also higher than with the closest expiration straddle. The breakeven here is around 5%, which is slightly higher but still manageable.

Notably, potential losses could reach up to 60%, while potential returns are around 100%, which is considerably higher for movements within a realistic range of 0 to approximately ±8%.

Even if the stock moves slightly, the loss doesn’t decrease significantly.

This reflects the nature of strangles — it’s essentially a make-or-break scenario where we can achieve substantial profits if the implied move is surpassed. However, if it’s not, or if it comes close to that threshold, we could incur losses.

How To Handle Exits

Now, let’s review the outcomes of these three classic volatility positions in light of recent events.

On the day of Morgan Stanley’s earnings, the stock initially opened at a 3% change, which was below our anticipated implied moves for all positions.

However, it later climbed to around 5% by the afternoon and continued rising over the next few days, peaking at 6% by week’s end.

This presents an interesting case study to analyze.

How do we exit or apply our strategy effectively? By setting and benchmarking against realistic targets, conducting thorough research, and calibrating our approach based on potential moves, we can navigate these scenarios effectively.

Conservative Approach

The exit strategy here is actually quite straightforward. Let’s consider the first scenario where we take a very conservative approach.

We’ll examine the classic straddle strategy with the closest expiration, comprising an 87 call and put option. Remember, this was a targeted position with a risk range of -30% to +50% in terms of potential gains or losses.

Once the market opens and we find the stock price is 3% below our breakeven point, which is lower than our anticipated maximum risk of 30%, a conservative exit strategy would be to accept this loss immediately. This means stopping the loss early.

If we were prepared for a 30% loss and the actual loss is only 10% at market open, it’s prudent to exit early and minimise the loss. This allows us to move forward and focus on the next trade.

Standard Approach

However, the standard approach, given our planned 30% risk tolerance, suggests holding the position until it hits that threshold, even if the initial loss at open is less than anticipated (e.g., 10% loss versus a planned 30% loss).

Typically, this threshold is reached either at market open or later in the day due to theta decay affecting the options’ value.

In this case, with the stock opening at a 3% move (about -10% in our position), we hold the position, anticipating a move towards our target loss of 30%.

As the day progresses, the stock slowly climbs to 4.5% and then 5%, turning our position profitable with a 10% gain.

This profitable outcome aligns with our trading thesis and, therefore, signals a normal exit.

Since we’ve achieved profitability without surpassing our maximum risk threshold, it’s sensible to close the position.

The key takeaway is the importance of setting predefined risk targets and adapting the exit strategy based on market movements and expected outcomes.

It’s crucial to be prepared to either accept the predefined maximum risk or exit early if the risk level becomes uncomfortable. This strategic approach ensures disciplined trading and risk management.

Risky Approach

In the alternate scenario, referred to as a risky exit, individuals who choose to engage in a straddle at the nearest expiration are likely prepared to incur even greater losses, potentially up to 60%.

This approach extends our earlier calibration into more adverse circumstances where such losses might accrue over the coming days if no significant stock movement.

Another strategy for exiting could involve accepting the current position and being open to assuming even higher risks — perhaps tolerating a 60% or 50% loss over subsequent days.

This willingness to endure more risk beyond the release period reflects comfort with substantial risk exposure.

It’s worth noting that if this level of risk tolerance applies, opting for a strangle strategy might be more suitable than using a straddle.

However, for those content with assuming heightened risk, holding on for longer periods may align with their risk appetite.

Morgan Stanley was a case where taking that risk paid off.

Over the next trading day following the release, the stock rose by 6%, surpassing our initial target and reaching a return of around 30%.

By being willing to take on the full risk through the first day and even pushing it to the maximum of 60%, we ended up with the most rewarding outcome.

The key is to feel comfortable with these target numbers before entering the trade, avoiding emotional reactions.

We can choose to approach this with a standard or conservative mindset, and these decisions can largely be automated, reducing the need for manual monitoring.

This allows us to apply these strategies in a neutral manner.