IBM Earnings Play, Modelling IV changes from earnings

Decided to put on a IBM earnings "spec" play. IBM reports earnings today after market close (AMC) and tomorrow is July expiration. What that does is jack up the vols (premium) of the July options, and tomorrow nearly all of that volatility will be gone. In buying a calendar, you sell all that front month volatility and will buy it back tomorrow after the vols have fallen. Normally, falling IVs are bad for calendars, but that's when the back month vols fall. In this case, the front month (July) will fall a TON, and the back month (Aug) will only fall a little.

Here's my trade as I put it on. I've also modelled an ATM straddle, which gives you a rough idea of what the market is pricing in for a earnings move. It's currently priced at $3.33, so the market thinks that the price of IBM after earnings will be within $108.40 +/- $3.33 (3%), or roughly 105 - 111.70. You can see that my break evens are outside of this range.

But with a horizontal (time) spread, you need to take into account volatility, and even more important, volatility skew and what will happen after earnings. That is, the difference of the vols from the short month to the back month. If you look at the IV of a far out (time) chain, such as Jan 10, you'll see that it's roughly 29%. You can expect the front and back months to lose some vol to approach that figure. Because it's expiration tomorrow, you won't see the front month go all the way to 29, but it's currently in the 60's and you might expect it to come down to 40-ish, shedding about 20 points of volatility. Similarly, the back month is slightly inflated due to earnings, so it too may come down, but not nearly as much. Maybe a couple points. Some stocks will have the back month come down a bit further, as much at 10 points or more in IV. So, how do you figure out what the trade will look like after expiration? thinkorswim has the tools to do so.

In the simulated trades page, to the top of the trades on the right, click the wrench, then click on the More drop down. Doing so will allow you to change the volatility of each month separately. In this case, I modelled a -20 point drop in the front month, and a -2 point drop in the back month. I also moved the date forward one day. You can see that my break even points are pulled in a bit, mostly from the -2 point drop in the back month. Be careful when doing this trade on stocks that you expect the back month to drop much more than 2 points, as the breakevens will be pulled quite a distance in. In this case, it still looks good...within the predicted range from the ATM straddle.

Since putting on this trade, IBM has climbed from $108.40 to $109.50, stressing my upper break even after pricing in the ATM straddle. IBM and the market was flat all morning and is now making a little run up during lunch here. It's possible, that at close, a simple 110 calendar could be a better play. Only time will tell.