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ANALYTICAL TOOLBOX: IV Seasonality Wrap-Up


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Clare White, Optionetics.com
January 25, 2007


A seven-year review of changes in both implied volatility [IV] and price near earnings announcements for Cisco Systems (CSCO) appears to display a seasonal trend. The key question is whether or not these trends provide an opportunity to traders. Are the changes significant enough to negate the impact of the bid-ask spread, commissions and taxes, and consistent enough to satisfy a reasonable risk-reward profile. It’s a tall order, but certainly one that appears to be worthwhile.

Strategy Review

Based upon the apparent seasonal movement in the IV for CSCO, the following two long, single option strategies were reviewed:  

  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.

 Next month options were evaluated to avoid accelerated IV decay within the 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.

Since the first two strategies did not provide returns that seemed to sufficiently account for costs associated with the trades, the extent to which one highly profitable (or highly unprofitable) impacted the results was not explored. In some cases, the IV movement seemed to be counter to what was expected. This outcome will be discussed later.

Two alternative strategies that may capture the most significant IV crush, that are also consistent with seasonal price movement 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 call spread* the day before earnings and close it two days later.

* Incorrectly identified as Bear Put Spread in last week’s article—seeking a credit.

Both of these strategies will benefit from declines in IV so near month and next month options can be evaluated. ATM, OTM and ITM options are reviewed here for the covered call strategy. Assuming the trader has an existing position of 100 shares for CSCO the following approach is taken:

  1. Earnings are released on 2/8/00;
  2. The day prior to the announcement date (2/7/00), sell a call at the close; then
  3. 3Buy the call back the day after earnings on 2/10/00.

Given a close of 125.19 for CSCO when the position is initiated, call options evaluated include Feb 125 [ATM], Feb 130 [OTM] and Feb 120 [ITM] for near month and Mar 125 [ATM], Mar 130 [OTM] and Mar 120 [ITM] for next month. The strategy was developed based upon the following two graphs which display seasonal changes in both IV and price (see previous article for more information on how the graph was developed). Figure 1 displays the results of average IV and price changes for CSCO from Jan 200 through Dec 2006, while Figure 2 displays median results. 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)

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

Results

Table 1, below, summarizes the quarterly results for the covered call strategy and includes the realized change in IV for the option along with the net gain or loss for the strategy without commissions.

Double-digit declines in IV are highlighted in green along with positive returns. Although IV changes varied by quarter, consistent gains were achieved with the strategy when using near month, in the money covered calls.

Table 1: Covered Call Strategy Review (2000-2006) Average Values by Quarter and All Quarters

Two concerns should immediately rise to the surface: 1) how did CSCO perform over the period and 2) how do commissions and taxes impact the strategy? Assuming CSCO was purchased on a split adjusted basis on 2/7/00 in order to employ this specific strategy, the stock position would have suffered an agonizing 56% decline, or $3,526.5 per 100 shares, through 2006. At current levels the equity exposure is less with CSCO trading near $26 per share.

In terms of transaction costs, the bid-ask spread has already been considered since historical closing data was used. However, the net gains of $246 per single contract trade is completely off-set by commissions, assuming round-trip costs of $16 per trade (28 trades x $16 = $448). Since economies of scale exist on the commission side, the approach still merits further review. Assuming an approach that includes 10 contracts and round-trip commissions of $30, gains of $2,460 are reduced to $1,620 over the entire period (28 x $30 = $840).

In terms of consistency, the maximum gain when selling the near month ITM call was $3.85 versus a maximum loss of $3.65. The average gain was $0.09 (insufficient on a single contract basis), the median gain was $0.05 and the standard deviation was 1.760. At first blush, there appears to be reasonable consistency to the results and actual returns versus risk-free returns would need to be evaluated.

In terms of a new system approach that includes the purchase of shares to specifically to carry out the strategy, the gains quickly appear insufficient to move forward ($26,220 at current levels). However, a trader currently employing a covered call strategy on existing stock may want to evaluate seasonal IV and price change trends around earnings for that stock. In addition, last week’s long call results may present a second, much more significant opportunity for the trader.

The long call strategy: buy a call the day after earnings and sell it two days later, resulted in losses of $11.65 per contract and significant IV declines. This strategy enters the position the same day the covered call strategy is exited and holds it for 2 days. Rather than the near month call, the data reflects next month values. What if the trader created a next month covered call position the day after earnings and sold it 2 days later?

Table 2: Strategy Summary (2000-2006) Average Values by Quarter and All Quarters

Summary

Three costs a trader should examine when reviewing a trading strategy include the bid-ask spread (slippage), commissions and taxes. Commissions have economies of scale—the costs associated with a one contract strategy are generally much higher than those associated with a ten contract strategy. Taxes are likely to represent the highest share of costs to a trader given the short-term nature of the strategies reviewed, unless the trades occur in a tax-deferred or tax-free account.

The impact of slippage has been … slipping in the options world. In addition to decimalization in the options markets, we’re beginning to see penny spreads in place of the more recent $0.05 and $0.10 increments. However, the benefit of narrowing spreads will likely only be realized in liquid contracts.

From a risk-reward standpoint, returns need to be evaluated. Another look at IV and price seasonality will be explored in March when strategies previously discussed in this article series are revisited.

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


  

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