By: Tom Gentile
on September 2nd, 2021
Have you ever gotten a speeding ticket and a few days later been inundated with law firm notices offering to get you out of hot water? Same thing for accidents. Legal firms scour public records looking to profit off the unfortunate. Some call them “ambulance chasers”.
Well, we can essentially do the same thing for stocks. Bad things happen to companies, even good companies. Poor earnings, SEC probes, lawsuits and global pandemics are just a few of the catalysts that can tank a stock.
It just happened to Zoom Video Communications (NYSE: ZM). Just a few days ago on August 30, Zoom announced earnings after the bell. A beneficiary of Covid-19, Zoom hit $1 billion in revenue for Q2. Great news, right? Yes, BUT, Zoom lowered future expectations. The stock was taken behind the woodshed and spanked dropping the stock from $347.50 to $289.50, a whopping 17%!
Now, what makes these kinds of setups super desirable is a little-understood component of option valuation. It’s called Implied Volatility (IV). IV will rise and fall based on demand for the options and expectation of what the stock may do. Generally, IV and the stock price are inversely correlated. As stocks rise, IV drops and vice versa. Also, IV tends to rise into earnings (green “E” triangles) and drop after.
In the Zoom chart above IV ran up into earnings. The poor news was announced and IV dropped, but due to the tanking, the IV still stayed high based on the average IV range. As stocks settle down, IV ultimately drops providing an excellent opportunity to profit.
The idea is to sell an expensive, high-probability credit spread at a level where you don’t expect the stock to go. A good place to do this is at support and resistance. Sell a bearish credit spread (Bear Call Spread) at resistance and a bullish credit spread at support (Bull Put Spread).
Here’s an example. The pink legs shown below constitute the bear call spread that profits as long as ZM stays at or below $320 by October 1.
The green legs are the bull put spread that profits as long as ZM stays above $260 by Oct 1.
Both credit spreads constitute an “iron condor”.
If ZM stays between $260 and $320 by October 1, both credit spreads expire worthless and the trade nets 42.27% over a 31-day period with exceptional probability of profit.
The above risk graph illustrates the P/L picture. The icing on the cake is that IV is still high and will drop as the stock normalizes.
Two days later, the stock went sideways and the IV dropped leaving the iron condor at a 6.3% profit with more profit to go.
Managing these trades is simple. As long as the stock stays between the sold option strikes, let both spreads expire worthless. If the stock closes above the short call or below the short put, shut down the trade and cut losses.
Here’s my high probability “Ambulance Chasing” system:
- Find stocks that tank on bad news.
- Sell a bear call spread at resistance.
- Sell a bull put spread at support.
- Use 14 to 30-day option expirations.
- If stock crosses above short call or below short put, exit the trade.
- Otherwise, let it expire worthless for maximum profit.