Earnings season can be a time of higher-than-typical volatility, which can mean an increase in risk as well as opportunity. Learn some of the options trading strategies you might use during earnings season.
Earnings season can be a time when stock prices may see larger-than-normal moves. Implied volatility (IV) may also rise to unusually high levels in the days or weeks leading up to an earnings release. That’s because an earnings report is considered as the company’s bill of health, and the information in the release can have a significant impact on share prices.
Analysts track companies by keeping an eye on key performance metrics, 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.
Many option traders view price movement as a potential opportunity. As such, there’s no shortage of stock options strategies that are popular during earnings season. Some involve a directional view while others look for the stock to remain within a specified range.
But before getting into specific earnings options strategies, let’s take a look at the market dynamics at work during earnings season. These include volatility, uncertainty, and the potential for an outsize move in the price of a stock as earnings data is incorporated.
A stock’s price is driven by various factors, but many investors say price is essentially the current value of expected profits in the future. Earnings data—earnings per share, revenue, net profit, and other numbers—can offer clues into the state of the company’s finances.
In conjunction with the earnings release, companies typically host a conference call where company executives offer guidance on future earnings and revenue, the state of the economy, the competitive landscape, and other information that might not be evident from reading the company’s financial reports. So the stakes can be high going into an earnings release.
If the company beats earnings expectations, there could be a significant move to the upside. In contrast, failing to meet expectations (an earnings miss) could potentially mean “look out below.” And when earnings are reported as being 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. After all, volatility is a measure of uncertainty. An earnings release essentially removes that uncertainty—for the current quarter, anyway.
If you’re an option trader and you have an opinion on the outcome of an upcoming release (maybe you think the company will blow away expectations and move higher or miss its number and move lower), it may be tempting to trade directionally with a simple long call or long put. But that may not be the best options strategy for earnings season.
Why? Because stock options prices are typically elevated thanks to higher implied volatility (vol) levels before the release. They often come back to earth after earnings are reported (see figure 1). So in order to profit from a single-leg options trade, you’d need to be right on the direction of the move and the move would need to be large enough to overcome a drop in implied volatility (and hence a drop in price).
FIGURE 1: VOL COMES TUMBLING DOWN. Implied volatility is a measure of uncertainty, and earnings season is a time of major uncertainty. When earnings are released (note the blue light bulb and the red telephone signifying the earnings release and conference call), the uncertainty is removed. The result, typically, is lower implied volatility. This dynamic can be key to understanding how to trade earnings with options. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Suppose you have a bullish view on a company’s upcoming earnings release and you’re considering trading earnings with options. Let’s run through a few sample options strategies:
For these examples, we’ll use the options prices in Table 1 below and assume that, after the company released its earnings, the stock rallied from $133 per share to $138—an increase of $5 or 3.75%.
The following, like all of our strategy discussions, is strictly for educational purposes. 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 these examples 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. Transaction costs for trades placed online at TD Ameritrade are $6.95 for stock orders and $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.
Before the earnings release, shares were trading at $133. Buying either the 135-strike call for $7 or the 140-strike call for $5 would’ve resulted in a loss the next day when the stock moved $5 higher to $138. Although 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.
Suppose that 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 offset the losses of the long option. In this example, the premium on the 135-140 call spread was $2 ($7 – $5 = $2). And for standard U.S. equity options, the multiplier is 100, so in dollar terms, the spread cost $200.
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After the earnings report came out, both options dropped in value, and the spread increased 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’ve gone down, or it could’ve 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’d lose your entire investment of $200, plus transaction costs.
Let’s use the same earnings scenario 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 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 spread strikes. If either of the 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 gain of 38%.
If, however, the stock were to rally above $155, or break below $125 at or before expiration, you’d likely have sustained the maximum loss of $3.20 times the multiplier of 100, or $320, plus transaction costs.
Earnings season is chock full of potential trading opportunities. But watch out for elevated implied volatility levels. Some investors will protect against high IV in their directional trading by using vertical spreads to dampen the risk of a volatility crush. Or they may consider range-bound option strategies, such as iron condors, to take advantage of predicted drops in implied volatility and profit if the stock remains inside the short strikes.
As any veteran option trader will tell you, these are just three strategies among many. For example, long put options can be used to hedge the exposure of an existing stock position. Or you could take advantage of the higher volatility ahead of earnings by selling a covered call on a stock position (but remember: A covered call opens up the risk of the stock being called away). You could put on a collar spread, which combines a long put and a covered call. That includes the covered call risk but now we’ve added the risk of losing the entire premium for the long put. As these examples make clear, options trading always involves risk, and as such, they’re not the right choice for everyone. To learn more about trading earnings announcements, watch the video below.
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