Earnings season is upon us again and the elections are right around the corner. Learn options strategies to trade earnings season and the upcoming elections.
Last quarter we wrote an article ahead of Q1 earnings season and discussed how to use risk-defined option strategies during earnings. We want to expand on this discussion and extend our views on earnings, volatility, the upcoming elections, and news-driven markets.
First, some context. The stock market is generally flat so far in 2016, but has seen quite a bit of volatility. The Brexit vote surprised markets and sent volatility soaring as uncertainty increased. The market absorbed the downturn quickly, however, and moved forward as risks from the vote decreased. Now, investors might expect more uncertainty as we dive into quarterly earnings and the upcoming presidential election. This can be good news for option traders, as more uncertainty generally leads to higher volatility. And higher volatility can provide opportunities, but it can also hurt a portfolio that is not properly protected.
Before considering how to trade options around an earnings announcement, traders need to determine the direction in which they think a stock might move. This analysis is crucial because it can help traders select option strategies. There are strategies for price moves higher (bullish), lower (bearish), and even if you believe a stock won’t move much at all (neutral).
After determining a direction, at TradeWise, we then seek to trade risk-defined strategies so we know our potential risk for all trades. This helps us participate and still sleep at night.
A major concept traders need to understand about earnings is that, historically, a stock’s implied volatility (IV) typically rises ahead of an earnings report. Not because the stock is necessarily more or less volatile, but because there’s more uncertainty (or risk) around what will happen during an earnings announcement. Once earnings are announced, we usually see a “volatility crush,” meaning IV drops by a lot as option premiums decline quickly.
You can see this volatility crush in figure 1. This is a chart of Nike (NKE) implied volatility going into its earnings announcement and immediately afterward.
FIGURE 1: NIKE (NKE) IMPLIED VOLATILITY BEFORE AND AFTER EARNINGS.
This chart displays NKE’s implied volatility before and after earnings. Note the sharp drop the day after earnings were announced. Data source: CBOE. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
You can see in figure 1 that IV rose ahead of the earnings announcement at the end of June and fell quickly after the release later in the month. This happened because the uncertain earnings event had passed and traders had a clearer understanding of the company’s future. Good, bad, or indifferent, the market is more aware of things moving forward and doesn’t price in the added risk.
For example, if you were bullish on NKE going into the earnings event, a possible trade would have been a short put vertical. This is designed to take advantage of the elevated option premiums because traders could collect a credit of $0.80 (minus transaction costs) for this example. Subtract this from the width of the vertical strikes (55/52.5), and you come up with a risk of $1.70 versus a potential reward of $0.80 not including transaction costs. After earnings, volatility collapses, and time decay (theta) can be an advantage. These factors can reduce the closing price on a credit vertical. Traders in this position only need NKE to remain above the breakeven price of $54.20. The risk/reward profile of this example trade is in figure 2.
FIGURE 2: NKE SHORT PUT VERTICAL RISK AND REWARD PROFILE.
This sample short put vertical was constructed using the 52.5 and 55 strike puts. The breakeven level of this trade was $54.20. Data source: CBOE. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
Now, it’s not a 100% probability that volatility will drop, but in most cases we’ve researched, IV tends to drop quickly after an earnings announcement. Knowing this, and if you believe that IV will drop, you may want to consider option strategies in which you are a net seller. These strategies include short verticals and short iron condors as examples. At TradeWise, we initiate and manage these types of strategies for our clients while providing education and trade management skills.
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