Nvidia is showing extremely high implied volatility in the lead-up to the company's earnings announcement on Aug. 28.
There is also significant volatility skew, with short-term options showing much higher implied volatility than long-term options.
One way to take advantage of this skew is via a diagonal put spread.
This option strategy is an advanced strategy because it utilizes options over different expiration periods and different strike prices.
Let's look at an example:
Traders could sell an Aug. 30 put with a strike price of 101 and buy a Sept. 13 put with a strike price of 96.
As of Wednesday's close, the Aug. 30 put could be sold for around 1.70, and the Sept. 13 put could be bought for 1.62.
Trade Has No Risk On Upside
The trade would result in a net credit of around 5-10 cents, which means there is no risk on the upside. The worst that can happen is the puts expire worthless and the trader keeps the 10-cent credit.
The risk on the trade is on the downside, with a potential maximum loss of $490. This is calculated by taking the difference in the spread (5) multiplied by 100 and subtracting the premium received (10).
The maximum potential gain is around $700. That would occur if Nvidia stock closes right at 101 on Aug. 30.
The break-even price is estimated at around 95. The trade will do well if Nvidia stock stays above 100 for the next week or so.
Aiming for a return of around 10%-15% makes sense, and I would set a similar stop loss.
The worst-case scenario is a sharp drop in Nvidia stock early in the trade. For this reason, if the stock drops below 100 in the next few days, I would also consider closing the trade early to minimize losses.
The initial trade set up has a delta of 6. That means the position is roughly equivalent to owning six shares of Nvidia. Note that this delta number can change significantly as the stock starts to move.
Higher Volatility On Put Sold
One of the advantages of the trade is that the put we are selling has higher volatility (80%) than the put we are buying (70%). Just like stocks, when it comes to volatility, we want to buy low and sell high.
Closing before the earnings date of Aug. 28 will avoid earnings risk.
According to the IBD Stock Checkup, Nvidia stock is ranked No. 2 in its industry group. It has a Composite Rating of 98, an EPS Rating of 99 and a Relative Strength Rating of 98.
It's important to remember that options are risky and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decision.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on X/Twitter at @OptiontradinIQ
