Options Strategy for Technology Companies

Teik Kheong Tan

Asia E-University (AEU)
School of Graduate Studies
Kuala Lumpur, Malaysia
Corresponding email: tktan@ieee.org


Abstract- Product innovation in the technology ecosystem can be
enhanced through proper management of the supply chain.
While there are several strategies that technology investors favor
for profitability during the earning cycles, one of the strategies
utilized quite often is the short strangle. A short strangle is an
effective strategy with a theoretically unlimited risk. For
example, Googles recent earnings sent its share price up sharply
by 13.8%, breaking the $1,000 barrier for the first time and
increasing the companys value by nearly $40 billion within a
day. Such variations can be very costly for an investor who trades
around earnings using short strangles. The aim of this paper is to
debunk this myth and demonstrate how a short strangle can be
traded safely as long as certain requirements are met. We will
employ two companies in the technology sector to illustrate how
our criteria can help in making better trading decisions. Since the
volatility crush is the key determinant for profitability, we
modeled the crush between the implied volatility of the front and
next earliest expiration using Bayesian statistics. The accuracy of
the Bayesian model is quantified using the Google stock as an
example and it is shown that the method is reasonably accurate
even with sharp changes in volatility trends.

1. Introduction

By trading on corporate earnings, traders and investors can
reliably profit from the markets in all directions while
avoiding market risk for the entire quarter. On the average, the
turnover ratio of common stocks on the expiration date is
443% higher than other Fridays on the earning week [1]. Since
trading around earnings is a highly volatile event, the selling
of strangles can be profitable due to the volatility crush but
this also comes with added risk. The study on information
disclosures and their associated risks have been a topic of
extensive research since Ball and Browns [2] pioneering
work. Some of these risks can be mitigated by qualifying the
trade appropriately. This is the focus of the paper. The aim is
to carefully qualify potential trades based on certain
parameters that provide a margin of safety. There are several
strategies that are known to be profitable in trading around
earnings. We will discuss one of them - the short strangle.

2. General Criteria for Short Strangle Application

We summarize the key criteria for applying a short strangle.
Liquidity, Volume and Open Interest: These 3 parameters are
the most critical but are often overlooked. Liquidity refers to
the tightness of the option bid/ask spread and is characterized
by a high level of trading activity. The minimum acceptable
volume for the front month strike must be at least 500 and the
open interest must be at least 1000. Ideally, we would prefer
the difference to be 1 cent and normally this is hard to achieve.
If we are shorting a strangle, we will accept no more than a 10
cent bid/ask spread.
Implied Volatility (IV): This is the estimated volatility of a
stocks price. Many papers on forecasting IV have been
published. Some of the more common models use variable
based asset pricing to determine equity and option pricing. A
good coverage is provided by Rossi [3] and Pastor and
Veronesi [4]. Upcoming announcements create uncertainty in
the option market prices by increasing the premiums and this
is reflected in the IV of the options. This phenomenon is well
documented in Dubinsky and Johannes [5]. However, up till
now, there are no models that can predict IV perfectly,
especially before earnings announcements. The distortion in
IV before earnings is what option traders capitalize on during
quarterly earnings. Google reported its last earnings on Oct
17
th
, 2013 and it turned out to be a blowout quarter. Without
proper adherence to these criteria, there would be substantial
loss as highlighted in the Google example below.
Figure 1 shows that Googles Oct volatility is at 72.12%
and the Nov volatility is around 32%. This is about 2.5 times
historical volatility. At least 2 times historical volatility is
typically needed for a short strangle to be considered. Ideally,
3 to 4 times historical volatility is preferred, which may
happen 5 or 6 times for each earning cycle. Given the criteria
of at least 2 times the historical volatility, this means that with
the 2.5 times result, the criteria is met. We conducted a
Bayesian analysis around the differential IV for Google to
ensure that the differential IV does not exceed the mean. We
forecasted the IV trend for the current week (where earnings
are announced) as well as the next 3 weeks in order to observe
the volatility crush. Our forecast is based on observation of
Googles earnings for the past two years. Since Google is still
considered a growth company, its stock movement
characteristic should reflect as such. For example, based on
historical earnings behavior, our expectation of the IV of
Google prior to earnings would be a normal distribution with a
mean of 80% and a 50% probability of being between 65%
and 95%. This expectation is derived from historical earnings
for the past 2 years for a high technology growth company.
Table 1 below shows the actual versus assumed IV. All
options have a limited useful lifespan and every option
contract is defined by an expiration month or week. The
option expiration date is the date on which an options contract
becomes invalid and the right to exercise it no longer exists.
For example, in the Options Expiration column for Oct 13 (1)
100, (1) represents the number of days to expiration. Since Oct
13 represents the regular options expiration on the third week
of Oct, it also represents the number of days to the options
expiration on Friday for that particular week. The data chosen
for the assumed IV reflects the most recent performance (up
till its most recent earnings announcement) of the prior quarter
adjusted upwards by about 2%. Quarter 3 is generally
considered a strong quarter for Google (and other technology
stocks) [6].

Table 1: Actual IV versus assumed IV for GOOG.
Decision Point
Expira
tion #
Options
Expiration
Actual
IV
Assumed
IV
Actual -
Assumed
Mean of
Distribution
0 Oct 13 (1) 100 75.12 80.34 0.00 80.00
1 Oct4 13 (8) 100
(Weeklys)
32.52 36.60 -4.08 75.16
2 Nov1 13 (15) 100
(Weeklys)
26.24 28.53 -2.29 73.89
3 Nov2 13 (22) 100
(Weeklys)
23.78 26.49 -2.71 73.13
4 Nov 13 (29) 100 23.32 24.86 -1.54 73.26

3. Bayesian Analysis

Before delving into the mechanics of our Bayesian analysis, it
is worth highlighting the motivation for this method versus
classical inference. First, it is highly flexible and it allows the
use of real market data to improve on the inferences. All the
inferences follow the same form from setting up the likelihood
and prior distributions, then calculating the posterior by
conditioning on observed data via Bayes theorem. This is
especially helpful in event driven days such as earnings where
the sentiment of the market towards risk (as reflected in the IV
percentile) can shift dramatically before and after earnings are
announced. Often times, after the conference call, the
management of the underlying company can further
accentuate the move during the extended hour trading session
which results in a gap during normal trading hours.
Figure 2 shows the prior and posterior distributions for our
Google IV differential forecast before earnings are announced.
First we consider the prior distribution. Rather than simply
setting a uniform prior or using a linear approach, we looked
back at the historical IVs for Google for the past 2 years.
Google reports its quarterly earnings after market close on
Thursday of the weekly expiration. This implies there is only 1
day before options expire for that week. However, the
historical IV of Google suggests that the following 1 and 2
weeks after earnings also experience a similar rise in IV
(although not as pronounced). This is shown in Table 1.
Rather than setting a uniform prior across models, we select a
uniform prior across volatility differences between expiration
functions. This column is labeled as Expiration # in Table 1.
In other words, let the prior be proportional to the historical
weighted average of Google for prior 8 quarters (2 years) with
bias towards the last 3 quarter. To estimate this, we consider
the parameter range of integers between 10 and 205, inclusive,
and calculate the prior probability and maximum likelihood
respectively. We repeat this with data for the next 4 weeks.
We select an appropriate mean (in our case 80 percentile) as
the highest volatility reached just before earnings are released.
We do not forecast just 1 point. We allowed for our
uncertainly by forecasting a probability distribution. In this
case, we expect the highest volatility for Google just prior to
earnings release would be distributed in a bell curve with a
mean of 80% and a 50% probability of being between 65%
and 95%. We selected a time horizon of 4 weeks with the
week of earnings release modeled as week 0. The first
computation is to determine the lognormal parameters for the
mean and standard deviation [7]. The mean of the natural log
of the forecasted IV, in terms of forecasted mean T and
standard deviation , is computed as
( )
|
|
.
|

\
|
+ = 1 ln 5 . 0 ln
2
2
T
T
o
(1)
where T = 80 and = 15/0.666.

The standard deviation of the natural log of the IV, o in terms
of the forecasted mean, T and standard deviation o is
computed as
|
|
.
|

\
|
+ = 1 ln '
2
2
T
o
o (2)

The computation for the linear parameters such as the mean
and standard deviation are as follows. The mean is obtained by
summing the products of the IV (between 10 and 205) and the
corresponding posterior probability of expiration week #
(where # = 1, 2 and 3). To understand how IV crush can be
helpful in deciding the appropriate options strategy, we need
to understand the key assumption made by researchers who
build volatility differential models: the statistical distribution
of the IV. The two most common types used are the normal
and lognormal distributions. The normal distribution gives
equal chance of volatility occurring either above or below the
mean. However, it is more common for market participants to
use the lognormal variety. Hence, we will use the lognormal
distribution parameters to generate our probability
distributions. The decision point for our studies depends on
the mean of the distribution. If there is a significant deviation
between the actual and the assumed for expirations 1, 2, 3, and
4, it would indicate that the strangle is too close to the
expected move, which gives standard deviation of 1.
Statistically, the IV is a proxy for standard deviation. By
comparing the posterior distribution curves after week 1, 2 and
3 with the prior distribution, we note that the middle sections
of the posteriors are well within that of the prior. Based on this
Bayesian analysis, we observed no anomaly in the third
quarter Google earnings from a differential implied volatility
perspective. However, the next section on premium collection
indicates a premium that is insufficient if we are to observe the
expected move criteria.
Premium collection for GOOG: The expected move to
the upside is $32 which is around $920. If $35 is subtracted
from the $888 price point, the price would be around $856.
Hence, $856 - $920 is the expected move range. This will be
reflected in the strangle and a determination is made from
here. If $920 is selected on the CALL and $855 on the PUT, it
shows a credit of $8.30 (Figure 3). However, the credit is
insufficient. At the current price of $888, 1% of $888 is $8.88.
In this case, the credit of $8.25 is just over 1%. In order to
meet the 2% minimum acceptable credit, at least $18 is
required. If the strikes are changed to $905 and $870, it gets
closer to the 2% minimum credit (Figure 4). However, this is 3
strikes closer, which is way too risky and violates the 1.5
times outside the expected move criteria. An analysis of the
expected move range is indicated in Figure 5. The position is
outside the expected move range but only by about 1.1 times.
As stipulated earlier, the requirement is at least 1.5 times
outside the expected move range. Based on current numbers in
Google, it would not meet the criteria for a short strangle. As
it turned out, Google reported earnings on Oct 17, 2013 which
exceeded the expected move by $56 to the upside! (Figure 6).
After the bullish earnings conference call the following
morning, the stock price increased further resulting in closing
price of around $1010. This 3.8x increase in expected move
annihilated many traders who sold strangles without following
the criteria outlined above. Adherence to the criteria would
have saved at least $9,000 per contract for the trader. Googles
stock price has never looked back since then and is currently
(Jan 10, 2014) trading at around $1130.

Undefined Risk: Selling a strangle can be a daunting exercise
because it has unlimited theoretical risk. How can the potential
capital per spread we are risking be estimated from a
probability perspective? Table 2 shows a buying power effect
of $24,125. Essentially, this indicates risking $24,125 to
potentially making $905. The objective is to take advantage of
the inflated IV going into earnings event by being a net seller
of that volatility premium inflation and hoping that the stock
stay within the range and all of the increased volatility
premium inflation decays overnight.

Table 2: Buying power effect
.
When the decay normalizes, for example in Google, where it
gets up to 75%-80% IV, and then the following morning after
earnings, in the first 30 minutes of trading, it normalizes to
about 35%. This roughly represents a 50% reduction in
volatility premium overnight. By being the net seller of that
volatility premium, one is selling the volatility premium at
inflated prices and hopefully buying them back after the
volatility crush has taken place the next day.


4. Extension to Other Technology Stocks and Future Work
We have further tested our analysis on the EBAY stock to
confirm the soundness of the above criteria for technology
companies. Due to space constraint, we have omitted the
results. Our future work will involve developing more
elaborate models to compare with the Bayesian method of
analysis as well as testing our analysis on more stocks with
different volatility trends.

5. Conclusions

Selling a strangle may not be as risky as portrayed by the
investment community. It can achieve a high probability of
success provided certain criteria are met. As long as the
specific criteria/parameters are in place and adhered to,
success in selling strangles into earnings is almost assured.
The criteria for qualifying a short strangle during earnings
seasons are listed as follows:
- Liquidity, Volume and Open Interest must be met.
- The IV differential should be 2 times or greater than
historical volatility.
- Avoid stocks that have a tendency to make huge moves in
the past on earnings.
- Buying power effect is significant in comparison to the
portfolio status.
- Min acceptable credit should be 2% of the stock price.
- The lower and upper breakeven thresholds should be 1.5
times or greater outside the expected move range.
Bayesian statistical analysis provides a useful model for
the IV behavior of the earnings for the front week and
subsequent 3 weeks. The accuracy of model has been
quantified using the Google stock. It has been shown that even
with sharp volatility trends, the method is reasonably accurate.
Maintaining a mechanical approach towards selling strangles
takes the emotions out of the trade, which results in better
chance of success. We have demonstrated how the criteria can
keep us mechanical if they are followed strictly.

References

[1] C-H Chiang, The Impact of Option Expiration and the Timing
of Earnings Announcements on Stock Returns and Trading Volume,
Doctor of Philosophy Thesis, Graduate School of Arts and Sciences,
Columbia University, pp. 3 - 4, 2010.
[2] R. Ball and P. Brown, An Empirical Evaluation of Accounting
Income Numbers, Journal of Accounting Research 6, pp. 159 - 178,
1968.
[3] A. Rossi, The Britten-Jones and Neuberger Smile-Consistent
with stochastic volatility option pricing model - a further analysis,
International Journal of Theoretical and Applied Finance, 2002.
[4] L. Pstor and P. Veronesi, Technological Revolutions and Stock
Prices, American Economic Review, American Economic
Association, vol. 99(4), pp. 51 - 83, September 2009.
[5] M. Johannes and A. Dubinsky, Earnings Announcements and
Option Prices, Graduate School of Business, Columbia University,
June 2005.
[6] G. Pupo, The Bull and Bear Tech Stock Report, 4
th
Quarter 2013 -
TSR-1013, The Tech Stock Report Oct 2013, pp. 1 - 3.
[7] Reliawiki, The Lognormal Distribution,
http://reliawiki.org/index.php/The_Lognormal_Distribution, pp 2-3.


Figure 1: Google options chain.


Figure 2: Bayesian probability distributions for Google IV differential. The x-axis represents the IV percentile and the y-axis the
probability. The 80% IV percentiles of the posterior distributions are well within the prior distribution.


Figure 3: Credit from selling Google strangle at strikes of $920 CALL and $855 PUT is $8.30. This is still outside the expected move.


Figure 4: Changing the strikes to $905 and $870 increases the credit to $17.70. However, this increases the risk (3 strikes closer) and
falls within the expected move which violates our expected move criteria.


Figure 5: Risk profile for short strangle on Google. The x-axis represents the stock price and the y-axis the profit. The red line shows
profits and losses at expiration (after 4 days in the example above) while the white line (lighter shade) shows profits and losses at the
current date (Oct 17, 2013). Even though it passes the criteria for premium collection, however it falls inside the expected move ($32).
To compute the expected move, we subtract $32 from closing price of $888 for the PUT strike and add $32 to closing price of $888
for the CALL strike.


Figure 6: Google gaps up by $88 after earnings.