The steel stock that has the shorts and options traders on edge

Fool me once, shame on you. Fool me twice, shame on me. That seems to be the refrain for Cleveland-Cliffs investors as the steel giant prepares to report earnings.

Cleveland-Cliffs steps into the earnings spotlight on Oct.19, and options traders are bracing for impact. After a massive, nearly 16% one-day price jump following its July quarterly report — nearly double its long-term historical average move of slightly over 8% — short-term implied volatility (IV) has been aggressively bid up as traders fear a repeat. And who could blame them? Short interest is running close to 14%, and the CEO is famous for fighting the naysayers, noting that he likes boil them "like frogs" and that they are "messing with the wrong guy."

With rhetoric like that, it's little wonder options traders are bracing for big moves. 

For strategic premium sellers, this inflated near-term fear creates a compelling opportunity to deploy what I call a "strangle-swap." You'll sometimes see traders or strategists refer to this as a "double-diagonal" spread. This structure allows traders to capitalize on the anticipated post-earnings decline in implied volatility (aka "vol crush") without taking on the unlimited risk of a naked short strangle.

To execute this strangle-swap, you sell a shorter-dated strangle and buy a longer-dated strangle to define your risk.

Sell to Open: 

• Sell November 11 Puts @ $0.43
• Sell November 17 Call @ $0.25) 
• Buy January 10 Put for $0.49
• Buy January 18 Call for $0.43
• Total net debit = $0.24 
• Net Cost: $24 per spread (recall each contract represents 100 shares)

The key to this trade is the differential in IV decay between the shorter-dated November expirations being sold and the longer-dated January options being purchased. Traders are heavily bidding November options on concerns that the sharp move from the last quarterly earnings release may repeat. Whether it does or doesn't, that binary uncertainty vanishes after CLF reports on the 19th, causing November implied volatility (IV) to collapse, a phenomenon commonly known as "vol crush."

Cleveland-Cliffs, YTD

Because the January options have significantly more days to expiration, they are less sensitive to this immediate IV crush and suffer much slower time decay (theta).

This trade is most profitable if CLF stays between $11 and $17 after the report. In this scenario, the November short strangle rapidly bleeds value. A trader can then buy back the short legs for a fraction of the $0.80 initially collected, or let them expire worthless. This leaves the trader holding a long January 10/18 strangle for virtually nothing, providing "free" exposure to future price swings through year-end.

This strategy loses money if CLF repeats or exceeds its explosive July fireworks. Because the short strikes (11/17) are narrower than the long strikes (10/18), a massive directional move will cause the short options' intrinsic value to expand faster than the long options can offset it in the short term.

However, the risk/reward profile is highly asymmetrical. The long January wings strictly define catastrophic risk.

Maximum Downside Risk: The width of the put spread ($1.00) plus the net debit ($0.24) = $1.24 ($124 per contract).

Maximum Upside Risk: The width of the call spread ($1.00) plus the net debit ($0.24) = $1.24 ($124 per contract).

By risking up to ~$124 to capture elevated front-month premium, the double-diagonal offers a cheap, defined-risk vehicle to fade the market's recent earnings trauma while maintaining long-term optionality.

Disclosures: Disclosures: Tidal owns/holds all the securities mentioned in the article.

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