If we can appreciate that a near $600.0B market cap company can move an oversized 9% off an earnings reaction as Apple (AAPL) did earlier this week, Amazon’s (AMZN) price gap of about 14%, with its much smaller, but still gargantuan, $100.0B capitalization and similar blowout and below views guidance, should come as much less of surprise. Nonetheless, surprise it did, especially to option traders pricing in an expected move of 6% to 9% depending on various straddle, strangle and implied volatility calculations traders decided to use.
Personally, it’s our opinion that with Weeklys ATM April implieds in the 170s on Thursday and below the truly panicky and something really wrong levels of the less-heralded Wall Street idiom, “Sell 100, Buy 200 (IV)”; traders looking to get short non-directional premium in front of Amazon’s earnings couldn’t be faulted entirely. But, while a short straddle or strangle are the most direct means to position for earnings in this capacity, they’re also the type most tied to blowout risk when a strong outlier reaction like AMZN’s, which was a full 50% above pricing estimates, does occur.
Figure 1: Amazon (AMZN) Iron Fly vs. Short Straddle
Shown above is a comparison of an iron butterfly versus a short straddle using slightly worse than mid-market prices from last night’s close in front of Amazon’s report. The straddle was designed using one short Weeklys April 195 straddle for $14.45. The pricing reflects break-evens of 209.45 and 180.55 and a max profit of $1,445 at 195.
The iron butterfly, which is simply a synthetic long butterfly using a short bear call spread and short bull put spread, is a limited risk variation on the short vega, short gamma / curve straddle. This relationship relative to the short straddle is particularly valid when we’re dealing with a position that’s designed on the eve of expiration with earnings in the mix. That said, our comparison iron fly was constructed shorting the same 195 straddle while simultaneously purchasing the 215 call and 175 put, which act as the protective wings just like its regular way 175 / 195 / 215 long butterfly equivalent would.
A credit of $6.00 for the 195 / 175 bull put spread and $6.80 for the 195 / 215 bull call spread give the trader a maximum profit of $12.80 or $1,280 at 195. That’s only $165 or about 12% less than the described straddle if everything went picture perfect and shares ended up at the sold strike at Friday’s closing bell and markets were void of slippage considerations. Likewise, we can see how close the break-evens of the iron are in comparison to the short straddle. In fact, they’re less than 1%.
A much larger consideration and fully a reality variance between the two strategies today is the much wider loss of nearly $1,800 in the straddle. In the end and in a market which often enough defies both expectations and logic, AMZN’s massive stock reaction dictated the straddle’s open risk profile trumped the max profit potential by roughly $350, but one which could have been worse too. Compare that to the iron butterfly’s limited loss of $720 or $7.20. Thus, while visions of a volatility crush, decay and non-movement resulting in a register ring of $1,280 may seem a bit silly now; it’s hard to deny the iron butterfly’s being much more prepared for today’s special occasion. And in another alternative reality; doing nearly as well.
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
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The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.