Thought Experiment: An IBM earnings play

Post-Final Update 8/2/2019: And the day after my paper exit, the market saw a significant decline, making the on-paper short iron condor on IBM profitable, at 14.8% of maximum potential profit. The on-paper price I’m using today is a 75 cent debit to exit, with shares trading for $146.62.

Interesting post-outcome. IBM proved to be an outlier on these trades, over and again. And the market itself, in the opening days of August, has proven to be stubborn mule with a mind not likely to listen to my expectations, or anyone else’s, for that matter.

Final Results 8/1/2019: My short iron condor paper trade on IBM, part of a thought experiment in hedging earnings plays, gave an exit signal today, ending the experiment.

It had two parts: One a short iron condor with a high probability of success, which I entered on paper on July 2, and a short iron fly with a lower probability of success, which I did as an actual trade on July 18. See IBM Analysis for details of the short-iron fly trade. The iron condor analysis is below.

The short iron condor position moved beyond the upper boundary of the profit zone, with a rate of change that meant it would take more than a day, at that rate, to return to the zone. Under my rules, with 15 days left until expiration, I was required to exit.

On paper, I exited IBM for $2.38, a $-150 loss per contract on the options, with shares trading for $151.88, or $11.66 above the entry price.

IBM rose sharply after earnings were announced, and rose sharply again today — two stormy punctuations amid a sideways flow.

Shares rose by 8.3% over 30 days, or a +101% annual rate. The options positions produced a 63.0% loss for a -767% annual rate.


This was about as close to a disaster as this method could have produced.: a 63.0% loss on the iron condor and a 20.2% loss on the iron fly. Had I just done the earnings play alone, the percentage loss would have been a quarter of the combined total. 

This is a sample size of one. Means nothing in itself. However, based on my experience with this trade, the results exceeded my worst nightmares. The risk estimates going into this experiment were based on the extremes: 100% losses and 100% wins. The interim results — read “actual results” — were more extreme.

I’ll continue to look at the question of how best to trade earnings announcements, but I’m not willing to jump in again without further study.

Last week I mused in an essay on how to expand the range of my high probability of success strategy by holding positions through an earnings announcement. The problem has always been that earnings announcements are by their very nature prone to surprises, and a surprise can take a wide iron condor, with 85% probabilities of success in either direction, and instantly turn it into a loser.

The strategy for trading earnings that I described is the polar opposite of my high probability strategy, which is longer-term, low report, low risk. In contrast, the earnings play strategy is short term, high reward, high risk.

The question is, can they work together, allowing me to hold iron condors on stocks through their earnings announcements.

IBM publishes earnings next Wednesday, July 17, after the closing bell. To get a better sense of how the two strategies interact, I’ve constructed two hypothetical trades. The first is a high probability trade, a paper trade using the August monthly options expiring Aug. 16 and entered 45 days before expiration. The second is a low probability earnings play using the July monthly options expiring July 19, two days after I enter the position.

Here’s what the analysis looks long for the longer-term trade with a higher probability of success:

International Business Machines Corp. (IBM)

I have, as a paper trade, on July 2 entered a short iron condor spread on IBM, using options that trade for the last time 45 days hence, on August 16. The premium is a $0.88 credit and the stock at the time of entry was priced at $140.22.

The profit zone for this position is between $150.88 on the upside and $120.88 on the downside.

The implied volatility rank (IVR) stands at (an estimated) 54%.

Paper Premium: $0.88 Expire OTM
IBM-iron condor Strike Odds Delta
Long 155.00 94.0% 6
Break-even 150.88 90.0% 11
Short 150.00 86.0% 16
Short 125.00 86.0% 12
Break-even 120.88 88.5% 9.5
Long 120.00 91.0% 7

The premium is 17.6% of the width of the position’s wings.

The risk/reward ratio is 4.7:1.

The hypothetical date of entry was July 2.

This is fairly typical of any of the high probability positions that I’ve been entering. A key metric to note is the risk/reward ratio. In this hypothetical trade, the most return I can gain is $88. The most I can lose is $412. That’s the price of setting the short-leg strike prices so far apart, and is why I’m reluctant to hold high probability low reward trades on stocks through an earnings announcement.

In this hypothetical exercise, on the trading day before the earnings announcement, I’m going to add in a second position, also an iron condor but sometimes called an “iron fly” to distinguish the two. While the short-leg strikes on most iron condors are different, they are in an iron fly the same.

For the iron fly, I’m entering the paper trade two days before expiration, on July 17, using the July monthlies expiring July 19. If the iron fly is profitable after the announcement, then I’ll let the position expire. If it is unprofitable, then I’ll attempt to exit on July 18 in order to reduce my loss.

The hypothetical iron fly analysis looks like this:

International Business Machines Corp. (IBM)

I have hypothetically entered a short iron fly spread on IBM, using options that trade for the last time two days hence, on July 19.

The premium is a $3.13 credit and the stock at the time of entry was priced at $142.52.

The profit zone for this position is between $146.13 on the upside and $142.19 on the downside.

The implied volatility rank (IVR) stands at 53.

Premium: $3.13 Expire OTM
IBM-iron fly Strike Odds Delta
Long 147.00 69.1% 33
Break-even 146.13 59.6% 42.8
Short 143.00 50.0% 52.6
Short 143.00 50.0% 47.4
Break-even 142.19 59.0% 38.7
Long 139.00 67.9% 30

The premium is 78.3% of the width of the position’s wings.

The risk/reward ratio is 0.3:1.

The hypothetical date of entry was July 17.

In setting up the iron fly trade, I aimed to set the long legs as close to a 30 delta as I could get. In this case that gave a reward that is nearly 10 times the risk. The return is capped at a comfortable $313 per contract, compared to a maximum loss of $87.

The result is a combined risk/reward ratio of 4.8, or a maximum loss of $499 per contract on the combined positions, and maximum win of $401 on the positions. A win/win on the two positions is more likely than a lose/lose outcome.

The lose/lose scenario adds $87 to my already considerable losses, so it’s not much in the way of additional pain.

A win on the high probability iron condor position combined with a loss on the low probability iron fly position would produce a $1 return per contract.

In the reverse, a win on the earnings play iron fly combined with a loss on the high probability iron condor produces an $99 loss, which produces a twinge of pain but falls short of a howl of agony. This is the least probable of the outcomes.

I find this to be an acceptable hedge. The most probable outcome saves me from a loss. The least probable saves me from catastrophe. And the best outcome gives a return nearly five times what I could expect from the high-probability iron condor alone. (The precise actual ratio is 3.6 times.)

It has the added advantage of giving me exposure to high volatility earnings plays while reducing the risk of such losses.

Next steps for this study:

On Thursday, July 18 (tomorrow), I’ll be looking at how the announcement impacted the price of the high-risk iron fly position. If it is in losing territory, I’ll try to exit. Otherwise, I’ll let the position expire.

On July 26 I’ll apply my normal non-earnings rules to the low-risk iron condor position and exit if there is any profit, no matter how low. If it’s not profitable, then I’ll continue to hold under the the sudden-death rules.

By Tim Bovee, Portland, Oregon, July 17, 2019


Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

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