Earnings season can create volatility in price movement. Learn how to spot potential options trade candidates by assessing straddle price versus average earnings moves.
Earnings season is an exciting time for traders. They await stock price direction, which in turn increases volatility, something option traders like to see.
Traders know that earnings announcements can be volatile events for the company reporting and have the potential to propel the stock higher or lower depending on the results. Options trading volumes tend to increase around these events as traders look to position themselves for these potential moves.
Options trading isn’t for everyone due to the increased level of risk involved, especially with the volatility over earnings. However, if you’re interested in trading the potential magnitude of an earnings move, here are some things you might want to know.
Now that there are weekly options expirations, you can get a pretty good idea of how big a potential earnings move is priced in by looking at the at-the-money (ATM) straddle that expires just after the earnings announcement (see figure 1).
Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
For example, let’s say company XYZ is releasing earnings on September 8 after the close. Before the release, you could look at the ATM straddle that expires on September 10 to gauge how the options traders are valuing the move. This ATM straddle price represents the expected magnitude of the underlying stock move following the earnings announcement, plus the options traders’ expectation of the stock move from then until the expiration of the option contract on September 10th.
For these options contracts expiring September 10, once the earnings have been released and disseminated throughout the marketplace, there are only two regular days of premium left.
The options market is not a perfect predictor. It doesn’t know what a company’s earnings will be or how a stock will react to the announcement. The options prices ahead of the earnings release are simply reflecting the supply and demand in those options contracts, along with the best guess of the potential move.
Let’s go back to the example. Suppose XYZ was trading at $388 prior to earnings, and the $387.50-strike straddle expiring September 10 is trading at $24. This may imply an expected move up to $412 or down to $364.
It’s impossible to figure out the future. But when analyzing stocks for potential earnings plays, one strategy may be to look at a stock’s average percentage move for the trading period following the earnings release over an extended period, say two years, as a benchmark. So, you’d look at the stock’s price change between the closing price on the day prior to the earnings announcement and the following day’s close. This could give you a general idea of how much the stock tends to move once the earnings have been disseminated throughout the market. And for the purpose of consistency, it may be helpful to convert the prices into percentages based on the prevailing stock price at the time of each earnings release.
Manually calculating the two-year average earnings moves can become tedious, time-consuming, and error-prone. The good news: On the thinkorswim platform, you can build your own scripts to automate tasks. And there’s one you can use that calculates the average percentage earnings move. The script also displays the individual percentage moves for each cycle in a graphical format overlaying the average move.
Interested in incorporating the script in thinkorswim? On the Charts tab, select the Setup gear icon in the top right corner, then Open shared item..., and copy and paste the following link into the box:
http://tos.mx/PCsqVK
Note: To display the individual earnings for the two-year period, the chart should be set to two-year daily.
Next, you’d convert the average percentage move into dollar terms by multiplying the percentage by the current stock price. This gives you the current average dollar move for the stock, based on earnings releases over the past two years.
Finally, we’ll compare the average dollar move to the price of the ATM straddle. Is the market pricing an earnings move greater than, less than, or about the same as the two-year average?
Keep in mind that past earnings moves are only being used as a reference. This does not mean the stock will react or move in the same manner in the future.
A short iron condor is a risk-defined options strategy consisting of a short call vertical spread paired with a short put vertical spread, with both spreads out of the money and typically centered around the current stock price. There are ways you can attempt to take advantage of elevated options premium during earnings. Here are a couple things to consider when iron condor hunting:
ATM straddle. Look at the Option Chain for the earnings week options expiration. Is the ATM straddle trading at a premium versus the two-year average dollar move, as explained above?
Timing. One strategy is to start looking at earnings plays within a couple days of the announcement. By initiating a short iron condor just prior to earnings, you can center the iron condor around the current underlying stock price. Plus, the closer you are to the earnings release, the more you can isolate the earnings move relative to other potential market-moving events.
So, now that we have discussed what might make an iron condor candidate, let’s look at an example. The table below shows the average earnings moves for an example stock over the past two years; the share price and the price of the ATM straddle on the day before the earnings release; and the actual net change in dollars on the day of the earnings release, in two subsequent quarters.
For illustrative purposes only. Past performance does not guarantee future results.
For both earnings releases, the ATM straddle was trading over the average move—a setup that might have been a good candidate for an iron condor. The actual move also came in above the average price move.
Although average earnings can be a helpful reference point to determine potential trade candidates during earnings season, it’s a tool and not something that predicts future price action. Average earnings can be used to help judge how the market might be valuing the upcoming earnings in relation to the average. Sometimes the market is pricing in a larger-than-average move for a reason, such as an expected product announcement or other highly anticipated release in conjunction with earnings. On the other hand, the company could go the other way and make an unexpected announcement, which could result in a greater-than-expected move.
Additionally, other factors such as heightened overall market and sector volatility should be taken into consideration because they can make a trade opportunity seem better than it might be, given the circumstances.
Assignment risk is something that is often overlooked, especially when the stock price closes between the long and short option positions. To minimize assignment risk, traders consider closing the vertical spread they judge to be in jeopardy or closing the entire Iron Condor prior to expiration/assignment. But, remember, assignment can occur regardless of the options being in- or out-of-the-money. Finally, the maximum loss on an Iron Condor is the difference between the strikes minus the credit received (plus the transaction fees.)
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