On Tuesday we detailed the positive situation at semi-conductor manufacturer Nvidia (NVDA - Free Report) going into their second quarter earnings announcement on Thursday after the close. In that report, we mentioned that based on the price of the at-the-money straddle that expires Friday afternoon, the options market is predicting a $16 move in the stock after the announcement – a fairly big move.
But what if the options markets are wrong?
Implied volatilities in NVDA are relatively high and the difference in volatilities between options strikes is very small, or in other words, the skew is relatively flat. That suggests that options market makers are somewhat uncertain about their implied volatility estimates.
We can execute an options trade with very limited risk and an attractive payoff if the shares move less than expected - an Iron Butterfly.
You’ll recall from previous Know Your Options articles that an iron butterfly involves selling an at-the-money straddle and buying an out of the money strangle.
It can also be thought of as selling a bear put vertical spread and selling a bull call spread. It’s exactly the same trade either way, so feel free to think of it whichever way makes more sense to you.
We’re going to use the options that expire Friday August 17th.
As of Wednesday’s close, the prices for the options we’re going to trade are:
AUG18 250 put $4.25 $4.40
AUG18 260 put $8.40 $8.60
AUG18 260 call $7.55 $7.70
AUG18 270 call $3.25 $3.40
If we buy one 250 put, sell one 260 put, sell one 260 call and buy one 270 call on the current market bids and offers, we collect $8.15. If we enter the order as a single spread, we can probably shave a bit of the bid/ask spreads and still get filled, so we’ll use $8.25 as our traded price for analysis.
The most that the spread can be worth is $10 if the stock is below $250 or above $270 at expiration. If that happens, we’ll lose $1.75 ($10 minus the $8.25 we collected to enter the trade) If, however, the announcement fails to move the shares that much, we will keep some of the premium we sold as profit. If the shares go exactly to $260, we’ll keep the entire $8.25 – a return of nearly 500% on the money we put at risk.
The p/l profile looks like:
There are a few caveats.
1) A trade with this type of potential payoff and so little time to expiration is basically a binary proposition. Either the stock moves significantly based on the report and we take the maximum loss of $1.75 (which is likely if you trust the options markets' assessment of a probable move) or the stock stays between 251.75 and 268.25 and we have a profit in the trade. Either way, there’s not enough time for anything else significant to occur and bail us out. It’s a quick win or lose scenario.
2) We experienced a somewhat volatile day in the broad markets on Wednesday. Even if the NVDA earnings are a dud and don't move the stock, it’s possible that a big selloff or rally in the major averages could drag NVDA along with it, eliminating the profits on our trade. Fridays during the summer tend to be slow, but that’s no guarantee we won’t see a big move.
3) Finally, because we are short at-the-money options, unless the stock goes quickly outside the $250-270 range and stays there (giving us the maximum $1.75 loss), we’re going to have to do a stock or option trade on Friday to close the short position that’s in-the-money to avoid having a position in the shares over the weekend. There’s a previous article about how to close trades here>>
This is a long-shot trade as evidenced by the nearly 5 to 1 payoff ratio, but with so little money at risk, it could also be a way to make some quick profits in the options markets.