A former hedge fund analyst who trades on his own time recently explained to us how he trades earnings announcements.

“This is one of my prop trades,” he told us. “I call it ‘exploiting the volatility crush.’

In the example he gave us, he made a little over $6,000 trading RIMM last fall. He put on a trade that went short September options and long October options for RIMM.

“Options are contracts that give you the option (but not the obligation) to buy or sell an asset at a certain price by a given time.” It’s kind of like insurance. The price of the insurance, the option, decreases as time goes on and uncertainty (volatility) decreases.

Or as he puts it, “Options are multi-dimensional and non-linear animals, governed by six components. Two of those components are volatility and time.”

It’s like this, he says, “People squirm watching a balloon get too much air blown into it. Will it pop now? NOW?” It’s human nature to freak out about uncertainty.

“Then they find out what happens and just like that, volatility (like uncertainty) rises before and collapses after earnings are announced.”

Usually, he says, the insurance that’s selling for September when the volatility and price is at its peak (before earnings are announced) is overpriced, and will fall later, so he’s almost guaranteed to make money shorting (selling) it. But just in case that doesn't happen, he has a hedge.

The trade he explained to us spans two days, Thursday September 16th, the date of RIMM’s earnings announcement, through Friday September 17th. The first part of it is shorting September options, because he assumes they are overpriced.

“I sold 70 [contracts] of September $42.50 [strike] options [puts] and 70 September $47.50 [strike] options [calls] before the market close on September 16th (RIMM reported earnings 10 minutes after market close, at 4:10pm EST)," he says.

“The idea is that both September and October should experience a volatility decline once the cat’s out of the bag, but September will probably be a more volatile month overall. So as a hedge, the second part of my trade is going long October options, because I want to sell an overpriced asset (the September options) and buy an underpriced one (the October options) because the former’s value decline should more than compensate for that in the latter.”

“So on the same day, I bought 70 RIMM October $50 options [calls] and 70 RIMM October $40 options [puts].”

Basically, his bet is simply that the month of September will be a more volatile month for RIMM than the month of October. Here’s how it played out.

“The trade’s sweet spot [when it’s most profitable] is if RIMM is between $42.5 and $47.5 by September 18th, when the option expires. I’d still be profitable but at a lesser rate if RIMM went either past $47.50 until $50 on the upside or past $42.50 until $40 to the downside, and I’d start losing money if it went slightly beyond $40 to $0 or slightly beyond $50 to the moon.”

The morning of Friday September 17th, RIMM’s opening price was $48.39. It traded as high as $48.74 and as low as $45.97 before closing at $46.72.

“The options I bought at average $0.21 per contract were sold at average of $1.12 per contract, and I netted approximately 533% in 2 days.”

Total profit: $6,370.00

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