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Trading Earnings Announcements without Getting Skewed

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July 1, 2013
short strangle trading earnings

Have verticals lost their va-va-va-voom? Butterflies gone blah? Straddles leaving you stranded? Looking for another strategy that will spice up your trading—even if it means more risk? Well, it ain’t the strategy. It’s the scenario. Sure, stocks and their volatility go up and down. But if you have the nerve, the capital, and risk appetite, you may want to consider a trade around earnings announcements.

The uncertainty around a stock’s quarterly earnings report can create high-volatility trading scenarios. Swings in price can be larger than average, and implied volatility in a stock’s options can pump up. Yet, you don’t really know what the stock will do when the report arrives. I wouldn’t blame you if you decided this all might be too risky. But there’s no harm in learning why some traders love the action.

FIGURE 1: VOLATILITY SKEW.

When implied volatility between months is notably different, as shown here—particularly between June and July expirations—we call it “skew.” The market calls it a possible time to slap a short strangle. Picture: thinkorswim. For illustrative purposes only.

Potatoe, Potahtoe

When earnings are announced, it’s binary. Something big can happen or nothing can happen without much in between. That’s not always the case. But stocks with very predictable (read “boring”) revenue and profit numbers aren’t the issue here. I’m focused on stocks where traders are battling it out in the options market. Some think the stock will move big up or down when the news arrives. Others think the stock won’t move nearly as much.

When options’ implied volatility is high, one group may be buying up options expecting a stock to rally or soon drop sharply. Other folks sometimes play chicken with the market and bet that the stock could move a little, but that the pumped up implied volatility will deflate.

A Tale of Two Strategies

Consider two strategies designed to take advantage of these earnings scenarios—one with little stock movement (non-directional), the other with some directional bias. Both strategies have risk, require capital, and demand your undivided attention in the minutes around announcements. Experienced earnings traders generally put options on a day or two before news hits— sometimes an hour or two before if the earnings come after the close of trading—and take them off for whatever profit or loss they have after the number arrives.

Going Sideways: The Short Strangle

If you think the stock will frustrate expectations, you could short a strangle by shorting a call and a put with different strikes (Figure 2). The call strike is typically higher than the put strike. The strategy is “naked” because there’s no hedge on either side of the trade to prevent unlimited losses from occurring.

FIGURE 2: SHORT STRANGLE FOR NON-TRENDING STOCKS. With implied volatility typically high before earnings, if you think the stock won’t move much after the announcement, the premiums from the short strangle will typically collapse, resulting in a potential profit on the trade. For illustrative purposes only.

First, the expiration month you might pick is the one where the implied volatility is highest. Go to the thinkorswim® platform and look at the Trade page and the option expirations. Along the right-hand side, you’ll see overall implied volatility for the options in each expiration—what I call the intermonth skew (see Figure 1). Is there one higher than the others, maybe 10 points higher or more? That higher implied volatility means the options’ time premiums are higher, relative to the other months’ options, and that can mean traders are buying options in expectation of a big earnings price change—either up or down.

When implied volatility is higher, the credit received for a short strangle is higher too. You get that credit in exchange for the extra risk of the stock making a big move, and it widens out the break-even points of the strangle, giving the stock more room to move up and down and still have the potential to be profitable. You speculate that the stock might move on the earnings but not too much. You’d sell the put at a strike below which you think the stock probably won’t drop. And sell the call at a strike above which you think the stock probably won’t rally.

Likewise, the short strangle has negative vega, or sensitivity to changes in implied volatility. If the implied volatility drops when the earnings come out, that would likely benefit the short strangle. Actually, the earnings uncertainty is causing higher implied volatility in a particular expiration month. Uncertainty typically gets reduced post-announcement, and the implied volatility drops back to roughly where it is in the other months. That skewed expiration month comes back into line.

That doesn’t happen all the time—volatility can increase after the announcement, particularly if there’s another simultaneous event that scares the market. And you never know how much the volatility might drop. Sometimes it drops a lot, a little, or not at all, depending on the stock.

The risk on a short strangle is unlimited. You don’t know how far the stock might drop or rally if you’re wrong. If the market gets surprised, the stock can move well beyond the strike prices of the strangle and cause large losses. For example, say the stock is currently at $100, and you think that it won’t move more than up or down five points on the earnings number. You might sell the 95 put and 105 call to create a strangle for, say, a $3.00 credit on options expiring in three days. That trade might make money if the price of the stock stayed between $95 and $105, and if implied volatility drops. But if the stock drops down to, say, $80, or rallies to $120, the loss could be at least $1,200, which is the difference between the higher strike price and the stock price, less the $3.00 credit received, not including transaction costs.*

That’s a lot of risk for the potential to earn a $300 max profit, which you might not fully capture if you buy the strangle back before it expires. And with three days to expiration in this case, there’s not a lot of time for the stock to move back to the profitable range of the strategy. That’s the tradeoff—you take a relatively large risk for a small, quick potential payoff. That’s why trading around earnings isn’t necessarily a bread-and-butter strategy, and why you’re wise to keep your position size small. With a short strangle, you take in the credit and keep your fingers crossed.

What about iron condors? Don’t they benefit from the stock not moving much and a drop in volatility? While you could sell an iron condor as an earnings trade on the same rationale as the short strangle, the nature of the volatility skew can reduce the credit you get for it. In many equities, the further out-of-the-money options have higher implied volatility. There are reasons for that, but the impact is that those options have relatively higher extrinsic value.

Selling an iron condor is selling a call and put that are closer to the current stock price, and buying a call and put that are further out of the money. The higher extrinsic value of those OTM options can mean the overall credit of the iron condor is reduced. That doesn’t mean that you’ll never find an iron condor candidate ahead of earnings. But the tendency is for iron condors to have much lower credits than short strangles when volatility is high. The tradeoff is that iron condors have defined risk, and typically lower capital requirements, than short strangles. Also, a 4-legged spread such as this can entail substantial transaction costs, including multiple commissions, which may impact any potential return.

Trending: The Ratio Spread

If you think the stock might move in a particular direction, but you still want to take advantage of the high volatility, consider a ratio spread (Figure 3), which is buying one closer out-of-the-money option, and selling two further out-of-the-money options. The credit from the two short options offsets the debit of the single long option.

FIGURE 3: PUT RATIO SPREADS FOR TRENDING STOCKS.

When implied volatility is high and you think a post-earnings breakout is imminent, the put ratio spread shown here is a bullish trade that serves up the potential for profit whether the upward move happens or not. For illustrative purposes only.

With the stock at $100, you might buy one 95 put and sell two 90 puts for, say, a $1.00 credit. This strategy would begin to lose money if the stock drops below $84.00, and has a maximum loss of $8,400(not including transaction costs*). The max profit is $600 if the stock is at $90, but would make at least $100 (the credit received) if the stock rallies (not including transaction costs*).

Why not just short a naked call if you’re bearish, or a put if you’re bullish, instead of a ratio spread? You could. But the ratio spread offers a little more room for error. Selling the 95 put naked would be a losing trade if the stock drops to $90. The ratio spread can be profitable, although less profitable than the naked put if the stock rallies. (Keep in mind that a naked put strategy such as this includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Also, consider the effect of transaction costs on a 3-legged options trade.)

Now you know what some aggressive options traders do around earnings. But use your insight wisely, brave trader. Even if you just want to watch earnings battles from a safe distance, keeping an eye on the skew can benefit you in other ways. But that’s for another day!

Talking Earnings

Your trading peers are chatting on myTrade® about earnings candidates they're watching. On the thinkorswim® platform, go to the Trade page, and select "myTrade" from the submenu. Type the ticker of the symbol of the earnings stock to filter to see how others are trading that stock with both directional and neutral strategies.