When a company releases earnings they provide the most recent financial performance and also give a guidance for the next quarters performance. A company's earnings can be a very volatile and profitable time if you use the right option strategy. Unfortunately most traders are taught to use the wrong option strategy and end up blowing out their account. We want to make sure this doesn't happen to you so we will show you what happens in the option markets when a company reports earnings, what strategies you shouldn't use, which ones you need to start using and then how to raise the probability of success and the profitability of these plays.
Option Markets And Company Earnings
When a company releases earnings there is an air of uncertainty over the market. Investors will use the guidance number to judge how a company is going to perform over the next three months. When the next batch of earnings comes out it will be judged upon these expectations and whether it beats, misses, or matches the guidance. A company could generate high revenue, profit and perform well but still receive a negative hit because it didn't beat its guidance.
This is a factor because the market will already price in the movement as if the company matched its guidance. When they miss or beat their earnings, an earnings surprise, this is where the uncertainty comes in. Now investors have to process this new information in a very short period of time, and this can cause the stock price to rise or drop significantly.
The uncertainty is translated into the option market through implied volatility. Implied volatility is what investors predict will be the future movement of the stock. The greater the implied volatility the greater the expected movement. Volatility will begin to rise into earnings as investors are uncertain as to which way the market will take the stock. The rise in volatility increases the option premium making everything more expensive. On the flip side of that coin, when earnings are released the volatility will drop dramatically because there is no more uncertainty. This is called volatility crush and it will drop the price of the options.
Why Short Options Are A Bad Idea
Most option traders understand the concept of volatility crush and construct their trades around this. The three most used earning strategies are short straddles, short strangles and iron condors. All of these strategies count on volatility coming in and the stock being stuck in a range. Since volatility was at a high this range is greater than it normally is, so these strategies seem like good ideas.
The reason these strategies are a bad idea is because there are a lot more earnings surprises than not. These surprises may still bring in volatility but they blow the range out. When tested, it was found that on average there was a 11.7% loss when you wrote a short straddle before earnings and bought it back right after earnings. If you are trading a short straddle or short strangle you are capping you profit and leaving your risk open. In normal situations this is okay because you can manage the position if it begins to turn sour. Earnings are released before the market opens or after the market is closed which is when the option market is closed, so there is no chance to adjust or close the position. When the market opens the stock is already outside of your range and your account begins to blowout. This is what you want to avoid. Selling options into earnings works until it doesn't and it erases all your gains and your portfolio.
What Option Trades Should You Take During Earnings
Surprisingly, the option strategies that perform well are long options. This goes against what most traders believe because they think volatility crushes the premium too much to make these trades profitable. However, as we previously discussed there are a lot more earning surprises than not. When focusing on long options we want to focus strictly on long straddles.
A long straddle involves buying a call and a put on the same strike and same maturity. This creates a non-directional play so you profit if the stock makes a large move up or down. The most important thing is that the move is a large one. Since you must buy two options it raises your breakeven price so a small move will still cost you money. It is this reason that buying a straddle under normal conditions, non-earnings, is difficult to make money. One study we looked at noted, "On average, straddles on individual stocks earn significantly negative returns: daily holding period return is -0.19% and weekly holding period return is -2.09%. In sharp contrast, straddle returns are significantly positive around earnings announcements: average at-the-money straddle returns from one day before earnings announcement to the earnings announcement date yields a highly significant 2.3% return."
When focusing on taking a position for earnings we want to get long our straddle at-the-money. Earnings can take a stock on a positive or negative track so we don't want to put on a bias when entering our position. Keeping the position at-the-money will allow us to profit if the move is in either direction. When deciding on the maturity always pick the shortest time to expiration. We need the most movement and most reaction out of the straddle.
The nice part about our earnings trades is we won't keep a lot of unnecessary risk on in terms of time. We want to put our straddle on the day before the earnings is announced. This will leave us set up for the announcement and nothing else, which is what we are aiming for. If you add the straddle on too early it could move and take it from being at-the-money to having a bullish or bearish bias.
When a company releases their earnings is when you want to exit the position. Wait towards the end of the day to be able to get the full movement out of the stock and exit the position. It doesn't matter if the position is showing a gain or a loss you still want to exit on earnings announcement day. Don't hold the straddle if it is a loser thinking it will move enough for you. When volatility comes out time decay will start weighing down on the position. The probability of success will drop off dramatically the longer you wait and the position will lose more money. Cut your losses and move on to the next one.
What Stocks Do You Want To Focus On
Stock selection is equally important to the success of this strategy. When we focus on stocks we want to remove all large cap stocks. Anything that you may find in the Dow Jones Average you want to avoid. The reason is that large cap stocks just don't move and there is not a lot of surprises in their earnings.
Lower cap stocks, like you find in the Russell 2000 make better candidates. These stocks have less shares on the market so they are easier to move. Also, analyst coverage is not as heavy on these stocks so there are a lot more surprises. Make sure that the options have enough volume and open interest before you make the trade. A lot of the smaller companies don't have an active option market so avoid these.;
When looking through this list of stocks you can narrow down your selection even further by looking at volatility. As we noted volatility is always on the rise during earnings but there are times when the market isn't pricing in a normal earnings movement. Take a look at a stock's chart and analyze how they moved over the last four earnings announcements. Write down what their one day movement was so we can compare it with the current expectation. After you have done that look at the current straddle price, what would you have to pay to long the straddle. If that price is significantly less than the average price over the last four quarters than there could be a lack of volatility in this announcement. For example if over the last four quarters a stocks one day movement was +18, -20, -22, +25 you can see the average movement is around 20. If the current straddle is only trading at a $15 premium this is below the average. For some reason people are deciding not to price this earnings in line with the previous four. Typically there is not an exact reason for this as it usually is just a mispricing.
These are the stocks you want to look for when trading long straddles on earnings. Not only is the probability of success higher but the straddle will be cheaper so less risk on the table if it doesn't work out.
|Long Straddle Greek Cheat Sheet|
Stay away from short options during earnings. They seem like a good idea but have a negative return and you could blowout your portfolio. Long options, especially long straddles, are the way to trade earnings. Straddles allow you to take advantage of large moves in either direction which is a perfect for earnings. When selecting the stocks you want to play focus on the smaller stocks with less coverage. These make better candidates for surprises. To raise your probability of success even higher try to find mispricings in the straddles when compared over the last four earnings announcements.
What are some ways you trade earnings? Let us know in the comments..