Earnings season is one of those times when stocks can see larger than normal moves. You also might see that the implied volatility has risen to unusually high levels in the days or weeks heading up to the earnings release. That’s because the earnings report is seen as the company’s bill of health, and the information in the release can have a significant effect on share prices.
Analysts track companies, keeping an eye on key performance metrics, and then issue reports on how a company’s most recent earnings report might affect future earnings. It’s these expectations that often drive the market’s reaction to the actual earnings report once it’s released each quarter.
Earnings Reports: Beat, Miss or Fall in Line
If the company beats earnings expectations, there could be significant move to the upside. Failing to meet expectations (an “earnings miss”) could potentially mean “look out below.” And when earnings are reported as “in line” with expectations there may be little movement at all. But in all three cases, once the release is issued and share prices have that initial reaction, the implied volatility that’s risen to lofty levels is likely to come crashing down. While a downward volatility move isn’t a guarantee, it’s quite typical.
When your outlook is either that the company will blow away expectations and move higher, or miss their number and move lower, if you’re an options trader, it may be tempting to trade directionally with just a simple long call or long put, but that may not be your best alternative. Why? Because option prices are typically elevated due to higher implied volatility levels before the release, and then come back to earth after the release. In other words, in order to profit from a trade, you’d need to be right on the direction of the move, and the move would need to be great enough to overcome the expected drop in the price of the option due to a drop in implied volatility.
So suppose you have a bullish view on a company’s upcoming earnings release. Let’s run through a few examples of some of your trade choices—buying a single-leg call, buying a long call vertical spread, and selling an iron condor. For these examples, we’ll use the options prices below.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Options trading involves unique risks and is not suitable for all investors. Please note that the examples below do not account for transaction costs or dividends. Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade. Transactions cost for trades placed online at TD Ameritrade are $6.95 for stock orders, $6.95 for option orders plus a $0.75 fee per contract. Orders placed by other means will have higher transaction costs. Options exercise and assignment fees are $19.99.
|Option||Day Before Earnings||After Earnings||% Difference|
|135-140 strikes call spread||$2.00||$2.55||+28%|
Alternative 1: Buying a Call
Consider the example stock in figure 1. Before the earnings release, shares are trading at $133. Buying either the 135-strike call for $7.00 or the 140-strike call for $5.00 would have resulted in a loss the next day when the stock moved $5.00 higher to $138. Although being right on direction, the 135 calls dropped to $6.45, which is an 8% loss; and the 140 calls dropped to $3.90, which is a 22% loss. That’s all because the implied volatility dropped back down to the lower part of its range.
Alternative 2: Buying a Call Vertical
Suppose instead of going with just a straight long call option you chose to buy a long vertical spread. In this example, you could buy the 135-140 call vertical by buying the 135 call and selling the 140 call. It’s still a bullish trade. But when the volatility drops, the short option in the spread helps to offset the losses of the long option. In this example, the 135-140 call spread costs $2.00 ($7.00 - $5.00 = $2.00. And for standard U.S. equity options, the multiplier is 100, so in dollar terms, the spread costs $200.
In the above example, after the earnings report comes out, both options drop in value, and the spread rose in value to $2.55 ($6.45 - $3.90 = $2.55), which would be a profit of 28%.
Of course, after the earnings release, the stock could have gone down, or it could have had a less pronounced rally. Remember: if the stock is below $135 at expiration, both options finish out of the money, in which case you would lose your entire investment of $200, plus transaction costs.
Alternative 3: Iron Condor
Let’s use the same earnings scenario as above and look at a different approach. Instead of looking to profit from movement, you can use an iron condor in an attempt to capitalize on the expected collapse of the implied volatility. An iron condor is a combination of two out-of-the-money short vertical spreads. Let’s say you sell the 130-strike put and buy the 125-strike put as a spread, and sell the 150-strike call and buy the 155-strike as a spread, for a net credit of $1.80.
Assuming the implied volatility drops after the earnings release, you’ll likely profit more from the short options of the iron condor than what you lose on the long options. That’s assuming the stock doesn’t blow through either of the spreads. If either of our verticals is more than $1.80 in-the-money at expiration, then this trade will likely lose.
But in this example, with the stock only moving $5 and the implied volatility retreating to the lower end of its range, this iron condor made $1.20 in one day. Dividing this profit by the maximum risk of $3.20, which is the $5 width of the vertical spread minus the entry credit of $1.80, would show a profit of 38%.
If, however, the stock were to rally above $155, or break below $125 at expiration, you would have sustained the maximum loss of $3.20, times the multiplier, or $320, plus transaction costs.
Earnings season is chock full of potential trading opportunities. But watch out for elevated implied volatility levels. Protect against it in your directional trading by using vertical spreads to dampen the risk of a volatility crush. Or use iron condors to take advantage of this predicted drop in the implied volatilities and profit if the stock remains inside your short strikes.
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