Earnings: Volatility’s Siren Song—Save Yourself From Surprises

Risky. Riskier. Riskiest. Nope, this isn’t a lesson on adjectives. But those three words describe three ways you might approach one of the more aggressive trading strategies out there: trading around corporate earnings. You might ask: How will a company’s numbers line up with expectations? Will they exceed or fall below those expectations, and by how much? How will the company frame future forecasts? A surprise in any of these areas can trigger a bullish or bearish price change that’s bigger than anyone expected, sending a stock dramatically higher or lower. 

Sure, just about any stock can move up or down 5% if you give it enough time (like a year). But an earnings surprise can pack a 5% move into a single day. In fact, it’s the speed and potential magnitude of a price change that creates risk. So, if trading around earnings is risky, why do it? 

It’s All About the Vol

Remember: implied volatility (“implied vol”) is a theoretical measure of how much a stock’s price might change in the future. Higher implied vol typically suggests future price changes could be large. It can also mean higher option prices. Thus, higher implied vol can mean certain trading opportunities for those willing to take on extra risk.

But what’s been missing in the market overall for most of the past couple of years? High implied vol. The CBOE Volatility Index (VIX), for example, has spent most of its time below 15 and its average is about 19. Traders looking to accept the risk of higher volatility (“vol”) for potential trading opportunities haven’t had the chance. That’s where the earnings play comes in. 

When there’s uncertainty around company earnings, the implied vol of the stock’s options tends to be higher before the announcement, even if the broader market’s vol is lower. To see this, take a look at the option chain on the Trade page of the thinkorswim^® trading platform from TD Ameritrade. On the right-hand side you’ll see the overall implied vol for each expiration.

In Figure 1, with an earnings announcement just four days away, the implied vol of the options that expire in four days is much higher than the vol of the later expirations. This suggests there’s more potential risk in the near term—that is, of possibly larger stock price changes in the next two days—versus further out in the future. The tendency for implied vol to fluctuate, plus the potential for larger price movements, are what can make earnings trades interesting in an otherwise dull market. And earnings come up every three months.

The earnings strategies described here focus on the options in the expiration closest to the earnings announcement, where this increased implied vol is reflected. You can tweak these strategies to match your specific stock outlook and appetite for risk. It’s also possible to trade around earnings announcements in longer-dated options to give your strategy more time. Which expiration you choose depends on your opinion of the stock. 

Keep in mind that earnings trades come in two flavors: either you think the stock will make a big move, as suggested by the high implied vol, or you think the stock won’t move as much as the high implied vol suggests. 

Risky: Long At-the-Money Vertical When You Think the Stock Will Move Big

This is a pure directional bet on what the stock’s price might do when earnings are announced. If you think the stock might rally, you could buy a call vertical. If you think the stock might drop, you could buy a put vertical. An at-the-money (ATM) vertical could be long the strike that’s the closest in-the-money (ITM) option, and short the strike that’s the closest out-of-the-money (OTM) option. For example, if the stock price is $80, a long ATM call vertical could be long the 79 call, and short the 81 call. 

The long vertical has defined risk, limited to the debit you pay for it. So it’s one of the less risky ways to trade earnings. But which vertical you buy is important. If you’re concerned about a change in the implied vol of the options after the announcement, you may want a vertical with relatively low vega. To get that, consider having the long and short options of the vertical at adjacent strikes, where the vega of the options could be roughly the same. In that case, the long vega from the option you’re buying, and the short vega from the option you’re selling, should offset each other. Maybe not completely, but enough to reduce the vega, or sensitivity to changes in implied vol from the long vertical.

Buying a vertical with only a few days to expiration means there’s not much time to adjust it if the stock goes against you. But the theoretical value of a long ATM vertical that’s close to expiration usually changes quickly when the stock’s price changes, so we can expect this to make it very responsive. Even if the stock doesn’t move as much as you expect, but still moves up or down in line with your speculation, the ATM vertical can still be profitable. So you may not want to buy a less expensive OTM vertical because if the stock doesn’t move enough, it can still expire worthless, even if the stock moves as you predicted.

Riskier: Iron Condor When You Think the Stock Won’t Move Big

When you use an iron condor for an earnings trade, you’re betting the stock won’t move up or down as much as the market expects. Ideally, the stock might stay in between the strike prices of the short options of the iron condor through expiration. But if the stock moves up or down, past the short strikes and even past the long strikes, the iron condor will lose money. For example, with the stock at $80, an iron condor might be long the 77 put, short the 79 put, short the 81 call, and long the 83 call. 

When implied vol is higher, the credit (which is also the max potential profit) for the iron condor is higher, all things being equal. That’s what makes iron condors an interesting, if riskier, earnings trade. If the stock stays between $79 and $81 after the earnings announcement, the trade can be profitable. If the stock moves past the breakeven points, which are the short put minus the credit and the short call plus the credit, the iron condor will lose money. 

Iron condors also have defined risk, with a max loss equal to the difference between the long and short strikes, minus the credit received. But if the difference between the long and short strikes is large, the loss is larger, too. The rationale for widening the iron condor is to increase the credit received. This depends on your risk appetite and how confident you are the stock won’t have a big price change. The closer the short strikes are to the prevailing stock price, and the further OTM the long strikes are, all things being equal, the higher the iron condor’s credit. But the risk is higher, too. That increased risk is why you’re getting a higher credit.

Riskiest: Short Straddle When You’re Confident the Stock Won’t Move Big

If you’re sure the stock won’t move as much on the earnings announcement as the rest of the market expects, and the higher implied vol of that stock’s options have too much premium, then you might consider selling a straddle. For example, with the stock price at $80, the short straddle could be short the 80 put and short the 80 call. When implied vol is higher, the credit received for selling the straddle is higher, too, all things being equal. And that higher credit means the potential profit can be higher, too. If you’re right. 

On the other hand, a short straddle has undefined risk, so you can’t measure the potential loss. And if the stock has a huge move up or down, the loss on a short straddle can be big, or even catastrophic. The breakeven points of the straddle are the strike price plus and minus the credit received. Even a moderate stock price change can blow through breakevens and cause a loss. 

That’s why the short straddle is one of the riskiest ways to trade earnings, but also has the highest potential profit. It reveals how profit and risk are linked. When the trade’s potential profit is high, so is the risk. 

In other words, earnings trades aren’t for everyone, and their short-term quality means they can be either winners or losers over just a few days. Further, there aren’t many ways to adjust or manage them. So regardless of your willingness to accept risk, you should keep your position small so that if the max loss does occur, you’re not wiped out. Finally, remember that commissions can really add up if you actively trade earnings.

But if you need to spice up your trading with an extra dose of risk, earnings may be something to consider.