Options Trading
Capitalize on Earnings Season
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How Has Aging Affected You?
Capitalize On Options Strategies for Earnings Season
While some buy and hold investors find big market swings to be unsettling, active traders often like high volatility because it brings the potential for big increases (or big declines) in stock prices. This type of market environment is often what we see during earnings season—when a large number of publicly traded companies release their quarterly earnings reports.
Earnings season can spell opportunity, and using the right strategy can help you take advantage of it. However, earnings season can just as easily spell disaster if you use the wrong strategy or if your forecast is incorrect. Sometimes what separates experienced traders from novices is not just how they try to profit on earnings season volatility, but also how they attempt to limit risks.
For most traders seeking to profit during earnings season, there are two basic schools of thought:
- Make the most of potentially higher volatility
- Take advantage of a price move without getting hurt by volatility
- Let’s take a look at both of these strategies.
In every earnings season, we usually see several stocks that exceed their earnings estimates and experience a big jump in price, and several others that fall short of their estimates and sustain a big price drop.
Predicting which stocks will beat expectations and which ones will miss is tricky. In my experience, I’ve often seen an increase in implied volatility in many stocks as the earnings release date approaches, followed by a very sharp drop in implied volatility immediately following the release.
Implied Volatility Definition:
Implied volatility is usually defined as the theoretical volatility of the underlying stock that is being implied by the quoted prices of that stock’s options. In other words, it’s the estimated future volatility of a security’s price.
How Does Implied Volatility Change With Earnings?
- Implied Volatility if Low about 1 week prior to earnings
- Implied volatility increases as earnings approaches
- Implied volatility is highest the day before earnings
- Implied volatility decreases immediately after earnings announcement
How Does Options Premiums Change with Volatility?
- Long and Short option premiums increase with volatility
- Longs and short option premiums decrease with volatility
- Both are affected equally
- Volatility drops drmatically after earnings
- Options premiums drop dramatically after earnings
- Even if stock price change dramatically it does not compensate for the drop in premiums
- Conclusion: Don’t play the stock– Play the Option instead
Because implied volatility is a non-directional calculation, any strategy that involves long options will typically gain value as volatility increases (before the earnings report)—meaning that puts and calls tend to be affected about equally. For the same reason, long option strategies will typically lose value quickly as volatility decreases (after the earnings report).
As a result, buying calls (or puts) outright to take advantage of an earnings report that you believe will beat (or miss) the earnings estimates is an extremely difficult strategy to execute.
This is because the drop in option value due to the decrease in volatility may wipe out most, if not all, of the increasing value related to any price change in the stock. In other words, a substantial price move in the right direction may be needed to end up with only a very small net gain overall.
Implied volatility is usually defined as the theoretical volatility of the underlying stock that is being implied by the quoted prices of that stock’s options. In other words, it’s the estimated future volatility of a security’s price.
While implied volatility spikes before earnings announcements will generally cause calls and puts to increase in value, those increases could be partially or completely offset by large price moves in the underlying stock.
Similarly, while implied volatility declines after earnings announcements will generally cause calls and puts to decrease sharply in value, those decreases could be partially or completely offset by large price moves in the underlying stock.
Strategies that may benefit from an increase in implied volatility include:
- ITM vertical credit spreads,
- short butterflies,
- short condors,
- ratio call back spreads and
- ratio put back spreads.
Strategies that may benefit from a decrease in implied volatility include:
- ITM (in-the-money) vertical debit spreads,
- long butterflies,
- long condors,
- ratio call spreads and
- ratio put spreads.
How Has Aging Affected You?
Strategy for Increasing Implied Volatility
Purchased about a week before earnings announcements, long calls, long puts and strategies including both, such as long straddles and long strangles, may be sold at a profit just prior to the announcements if they gain value as the implied volatility increases, even if the underlying stock price stays relatively unchanged.
- Purchase LONG Calls, Puts, or Strangles 1 week prior to earnings
- Sell the Call, Put, or Strangle the day before earnings
- Close all trades IMMEDIATELY after earnings
How Has Aging Affected You?
Strategy for Decreasing Implied Volatility
As discussed, long options tend to gain value as volatility increases, and tend to lose value as volatility decreases. Therefore, long calls, long puts, and long straddles will generally benefit from the increase in implied volatility that usually occurs just before an earnings report.
In contrast, short (naked) calls, short (naked or cash secured) puts, short straddles and strangles, if sold just before earnings, can sometimes be bought back at a profit just after earnings, if they lose enough value as the implied volatility decreases, regardless of whether the underlying stock price changes or not.
The key to profiting from these strategies is for the stock to remain relatively stable or at least stable enough so that the stock price change doesn’t completely cancel out the benefit of the decrease in volatility.
One way to estimate how much a stock price might change when earnings are announced is to forecast the (implied) move mathematically.
- Place a vertical credit spread the day before earning when volatility is high
- Hope both expire worthless
- The value of the spread will decrease as volatility drops as it does after earnings
Strategy particularly useful if you have a directional bias. As previously mentioned, implied volatility is the estimated volatility of a stock’s price that is being implied by the options on that stock.
As stock prices are usually forecasted using a normal distribution (or bell) curve, an option with an implied volatility of 30% is implying that the underlying stock will trade within a price range 30% higher to 30% lower about 68% of the time (one standard deviation) over a period of one year.
The formula for this calculation is:
- (Stock price) x (IV) x square root of time in years
- From this, you can determine how much the stock is expected to move during the life of an option contract. Manipulating the formula somewhat yields the following:
- (Stock price) x (IV) x square root of # days until the option expires
- Square root of # days in a year
Implied Move:
Because option prices tend to get more expensive as an earnings announcement approaches, a slight calculation variation can be used to forecast how much the stock is expected to move when the earnings come out. This formula is often called the “implied move.”
Often a key determinant in whether a stock will increase or decrease in price after earnings are announced is how closely the results align with the consensus of analysts’ expectations.
OOTM (out-of-the-money) vertical credit spreads also usually benefit from implied volatility decreases, because while they involve both long and short options
The goal of a vertical credit spread is to receive the credit up front and hope that both options expire worthless. A sharp decrease in implied volatility, such as ones usually occurring right after an earnings announcement, will often cause both legs to drop in price and become virtually worthless, unless there is a substantial price move in the stock that is large enough to completely offset the effect of the volatility drop.
These strategies are most effective when you have a directional bias and you are trying to reduce the risks associated with the sale of uncovered (naked) options. For example:
- If you believe the earnings report will exceed estimates, consider an OOTM credit put spread (a bullish strategy).
- If you believe the earnings report will fall short of estimates, consider an OOTM credit call spread (a bearish strategy).
Consider the following credit put spread example using a fictitious stock ZYX, currently trading around $51.00, if there is no price change in the stock ZYX after an earnings announcement, but implied volatility drops 30%, pricing would be as follows:
Opening trade
Buy 1 Jun 21, 2014 45 P @ $1.55 Implied volatility = 60%
Sell 1 Jun 21, 2014 50 P @ $3.10 Implied volatility = 54%
Net credit = 1.55
Implied volatility decreases by 30%
Closing trade
Sell 1 Jun 21, 2014 45 P @ $.30 Implied volatility = 30%
Buy 1 Jun 21, 2014 50 P @ $1.30 Implied volatility = 24%
Net debit = -1.00
As you can see, the net profit would be 0.55 (1.55 – 1.00) strictly due to the reduction in volatility.
As previously mentioned, implied volatility is the estimated volatility of a stock’s price that is being implied by the options on that stock. As stock prices are usually forecasted using a normal distribution (or bell) curve, an option with an implied volatility of 30% is implying that the underlying stock will trade within a price range 30% higher to 30% lower about 68% of the time (one standard deviation) over a period of one year.
The formula for this calculation is:
(Stock price) x (IV) x square root of time in years
From this, you can determine how much the stock is expected to move during the life of an option contract. Manipulating the formula somewhat yields the following:
(Stock price) x (IV) x square root of # days until the option expires
Square root of # days in a year
Because option prices tend to get more expensive as an earnings announcement approaches, a slight calculation variation can be used to forecast how much the stock is expected to move when the earnings come out. This formula is often called the “implied move.” For a stock due to announce earnings right after market close, the formula would be:
(Stock price) x (Implied volatility)
Square root of # days in a year
Referring to the above table, because XYZ was trading at approximately $17.75 per share prior to the first earnings report and the implied volatility of the front month ATM options was 72% just before earnings, the calculation below implies a 0.67 move in either direction. In other words, there is about a 68% chance that XYZ will increase in price up to $18.42 or drop in price down to $17.08 when the earnings are announced.
Earnings report one:
17.75 x .72
19.104 = .67
If we use this formula for the other three earnings reports above we get the following results:
Earnings report two:
15.03 x 1.31
19.104 = 1.03
Earnings report three:
17.61 x .94
19.104 = .87
Earnings report four:
20.43 x .70
19.104 = .75
How Has Aging Affected You?
Strategy That Neutralize Implied Volatility
Changes in volatility can often cancel out price changes or provide profitable opportunities even when there’s no price change.
But suppose you want to try to profit from an anticipated stock price change and avoid the complications created by the volatility component? Consider ATM vertical call spreads and ATM vertical put spreads.
- Set up a vertical credit spread ATM or one leg just a little OTM
- Set up just prior to earnings
- Close right after price jump ( or not )
Vertical spreads that are considered ATM usually have one leg just slightly ITM and one leg just slightly OTM.
In most cases, the implied volatility of the long leg and short leg will be very similar.
So any changes in volatility after the position is established will have very little impact on the net value of the spread, because they will largely cancel each other out.
However, ATM options typically carry the largest time values (relative to ITM or OOTM options) so they are also quite sensitive to price changes.
How Has Aging Affected You?
Strategy for Increasing Implied Volatility
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OOTM vertical debit spreads usually benefit from increases in implied volatility because while they involve both long and short options, the goal of a vertical debit spread is to pay a small debit up front and hope that both options expire ITM. A sharp increase in implied volatility (unless accompanied by a large price move), such as those usually occurring right before an earnings announcement, will often cause both legs to increase in price. The higher value long option will typically gain value faster than the short option.
Like credit spreads, these strategies are most effective when you have a directional bias and you are trying to reduce the cost associated with the purchase of long options. If you believe the stock price will trend higher before the earnings report, consider an OOTM debit call spread (a bullish strategy). If you believe the stock price will trend lower before the earnings report, consider an OOTM debit put spread (a bearish strategy).
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