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ANALYTICAL TOOLBOX: IV Seasonality Trade Review


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Clare White, Optionetics.com
January 18, 2007


Implied Volatility [IV] can appear to display seasonal tendencies that coincide with specific events, typically earnings. The IV chart for Cisco Systems (CSCO) provided in last week’s article (also included at the end of this article) is one such example. In order to take advantage of such seasonality, a review of strategies that capitalize on such movement is a reasonable next step.

Since the price of the underlying relative to the strike price and type of option is the most significant factor impacting option premium, a review of possible seasonal tendencies in price is also worth a review prior to strategy selection. Using average values for daily changes in 7-149 day IV and price over a 31 day period around earnings, a graph was developed to identify potential strategies. The horizontal line represents the period prior to earnings (20 trading days), the day earnings are released and the period immediately after the release (10 days).

Figure 1 displays the results of the analysis for CSCO from Jan 200 through Dec 2006 and also appeared in last week’s article. The rise and decline in IV changes around point 0 confirms the seasonality conclusion for CSCO IV. The trends in this graphic are used to identify two strategies to test that may capitalize on the movement. The vertical line coincides with Day 0, the trading day in which CSCO quarterly’s earnings are released.

Figure 1: CSCO Quarterly Price & IV Changes near Earnings Announcements (Average)

Strategy Review

IV peaks 1 day prior to the release of CSCO earnings which occurs after the close of trading. IV then appears to drop sharply the day after the release. At the same time price appears to decline somewhat prior to earnings, spike higher on the release date and then decline again for a couple of days. Price then appears to rise over the next two days.

Using long, single option position positions, the trader could:

  1. Buy a put 4 days prior to earnings and sell it three days later.
  2. Buy a call the day after earnings and sell it two days later.

In this example, the next month options were evaluated so the options always had more than 30 days to expiration. At the money [ATM],out of the money [OTM)] and in the money [ITM] strike prices were used, with ITM and OTM options 1 strike away from the ATM options. So for the first strategy:

  1. Earnings are released on 2/8/00
  2. 4 days prior to the announcement date (2/2/00) CSCO closed at 113.88
  3. Put options evaluated include Mar 115 [ATM],Mar 120 [OTM] and Mar 110 [ITM].

Since average IV and price changes were reviewed for this exercise, extreme high and low changes have the potential to skew the results shown in Figure 1. The trader also should watch for annual seasonality in price—that is movement related to rising markets in the first quarter and declining markets in the third quarter.

Results

Table 1 summarizes the strategy results for both the long put and long call strategies and includes the realized change in IV for the option and the net gain or loss for the strategy without commissions.

Table 1: Long Put and Long Call Strategy Review—Average Values by Quarter

Although it appeared IV was increasing over the three day period for the put strategy, only the results for the first quarter display a significant change. The call strategy two day results were worse. So did one extreme value skew the chart in Figure 1? Possibly, but a more significant factor in which the trader must contend is the option spread, and the impact this has on IV when buying and selling an option.

During the put trading period, the price for CSCO realized a maximum one day gain of 14.40% and a maximum loss of only 8.26%. IV had a maximum gain of 20.79% and maximum loss of 40.45%. The impact of these outliers will be examined next week. During the call trading period, the price for CSCO realized a maximum one day gain of 24.39% and a maximum loss of 10.61%. IV had a maximum gain of 16.75% and maximum loss of 32.84%.

Let’s review the same data—CSCO IV and price changes around earnings—median values instead. Each quarter is broken out separately to obtain the appropriate median value, the data reviewed and average median value used for the graph. The result is displayed in Figure 2:

Figure 2: CSCO Quarterly Price & IV Changes near Earnings Announcements (Median)

Since the results still display a compelling argument for strong seasonality, an alternative strategy that can capture the most significant IV crush that is consistent with price changes seems rational. Two such strategies that will be explored next week include the following:

  1. When owning stock, sell a covered call the day before earnings buy it back two days later.
  2. Create a bear put spread the day before earnings and close it two days later.

To see the other articles by this author, please click here.


Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

CSCO IV Seasonality:

Data Approach

Optionetics Platinum was used to obtain daily price and option data over 7 years for CSCO, including the following:

  1. Date,
  2. Open, high, low and close price data for CSCO
  3. Closing Volume for CSCO,
  4. Closing 90-, 20- and 10-day Statistical Volatility (SV)for CSCO, and
  5. Closing 7-149, >90, 30-60 and 7-30 day IV for CSCO options.

The data was collected from January 2000 through December 2006, so it includes 28 quarterly earnings periods. In order to evaluate IV characteristics around earnings, a few things calculations were performed. First, daily IV changes were evaluated rather than straight IV information—this provided more normalized data so that results for higher volatile periods (2000-2002) could be used with results for lower volatility periods (2004-2006).


  

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