Cleveland Cliff (CLF.US) earnings report is back! Options traders set up early to prevent sharp stock price fluctuations

If you've been “scammed” once, blame someone else; if you've been “cheated” twice, you can only blame yourself. For investors in Cleveland Cliff (CLF.US), this seems to be a phrase they keep on repeating as the steel giant prepares to release earnings reports.

The Zhitong Finance App learned that Cleveland Cliff's earnings report to be released on October 19 will be the focus of the market. Options traders, on the other hand, are waiting very hard. After the company announced its quarterly results in July, its stock price soared nearly 16% in a single day — almost double its long-term historical average daily fluctuation of just over 8%. Since then, traders are worried that similar markets will reappear, and they have greatly boosted the implied volatility (IV) of short-term options. Moreover, the current short position on this stock is close to 14%, and the company's CEO is famous for fighting tit-for-tat with empty players. He once said that he likes to “cook slowly like frogs” and that they “mislead people.”

With such remarks, it's no surprise that options traders are wary of possible sharp swings in Cleveland Cliff's stock price. For strategic option premium sellers, this fueled short-term panic creates an attractive opportunity to adopt a “strangle-swap” (strangle-swap) strategy. Traders or strategists sometimes refer to this strategy as a “double-diagonal” (double-diagonal) strategy. This structure allows traders to take advantage of the expected decline in implied volatility (the so-called “volatility squeeze” or “vol crush”) after the earnings report is released, while avoiding the unlimited risk of selling broad cross-type options.

To implement this “wide span swap” strategy, traders need to sell wide span options with a shorter maturity date and buy wide span options with a longer maturity date to limit the risk range. The key to this trading strategy is the difference in the rate of decline in implied volatility between the shorter-term 11-month option sold and the longer-term 1-month option bought.

Traders are buying November options in droves due to concerns that the sharp market that occurred after the announcement of the previous quarterly earnings report might be repeated. Regardless of whether this sharp fluctuation is repeated, once Cleveland Cliff releases its earnings report on the 19th, this binary uncertainty will disappear, leading to a sharp drop in the implied volatility of November options. This phenomenon is commonly known as “vol crush” (vol crush). However, since January options have significantly more time until their expiration date, they are less sensitive to this immediate sharp drop in implied volatility, while also experiencing a much slower decline in time value (THETA).

If Cleveland Cliff's stock price remains between $11 and $17 after the earnings report is released, the profitability of this trading strategy will reach its maximum. In this case, broad-span options sold in November will rapidly depreciate in value. Traders can then buy back these sold option legs with a small portion of the $0.80 premium they were initially charged, or let them return to zero at maturity. In this way, traders can continue to hold January 10/18 wide spread options at almost no cost, thereby gaining free exposure to future stock price fluctuations until the end of the year.

However, if Cleveland Cliff shares repeat or even surpass the July explosion, this strategy will lose money. Since the execution price range of $11/$17 is narrower than the execution price range of $10/$18, once the stock price fluctuates sharply in one direction, the intrinsic value of the sell option will grow faster than the rate at which the buy option can be offset in the short term.