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.
Election day in the U.S. is right around the corner, and polls are showing it’s likely to be a tight race heading into the home stretch. Although many investors have strongly held personal beliefs when it comes to politics, traders focus on the impact of the elections on the market and portfolios. It’s a potential market-moving event and could provide more volatility for stock and option markets. What will each candidate bring to the table that may negatively or positively affect a portfolio and the markets?
If Trump wins, could it spur economic growth? Might the banking sector stocks suffer? If Clinton wins, could pharmaceutical stocks suffer? Would energy stocks catch a bid? What sectors might be affected by each candidate? Could defense stocks rise if Trump gets elected? Might tech stocks rally if business investment is encouraged by Clinton?
What has taken place for stocks going into and immediately after elections?
Historically, major stock market lows have occurred surprisingly close to mid-year congressional elections, or approximately two years before/after presidential elections. For the most part, bear markets have historically occurred during the first or second years of presidential terms. (A bear market is defined here as the S&P 500 Index’s [SPX] decline of approximately 15% or more over a period of one to three years, while a bull market is an environment of consistently rising prices.)
We teach trading risk-defined strategies with any new speculative option positions, and encourage investors to hedge portfolio risk. Options expire, so the duration of trades is finite whether they are weekly or monthly cycles. This allows traders to have a specific time frame in which to place trades.
To summarize: Earnings season and the upcoming elections will most likely move markets and increase volatility. Using options for speculation, hedging, or portfolio protection may be beneficial as potential opportunities and risks arise. The risk-defined option strategies we trade may be one way to take advantage of the situation or potentially protect a portfolio in the event of any major market moves. So what’s next from here? Here are a couple things to do:
Characteristics and Risks of Standardized Options
TradeWise is a professional advisory service that specializes in educating investors on how to employ option strategies in current market conditions. If you would like to learn more about the versatility of options, visit our website at tradewise.com.
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Spreads, iron condors, and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
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