Earnings are coming, and you want to trade - I get it.
Not only can earnings season be an exciting and profitable time, but it can also be a very volatile time.
Maybe the company announced tremendous profits or disclosed more layoffs; either announcement could dramatically impact price movement. Typically, stocks surge higher or plunge lower depending on the information within the earnings release.
Depending on how much you understand about properly leveraging options, you can do very well or very poorly. Unfortunately, many investors use the wrong approach when it comes to options and earnings and are left wondering what happened.
However, with the right options strategy, earnings release season can be very profitable for well-educated options traders.
Keep reading to become one of those well-educated investors who can profit during earnings season. In this post, we will provide insight into:
What happens to the options market when companies report earnings
How to profitably leverage options after an earnings release
Options strategies to avoid
How to use options after a company releases earnings
So how do you trade options after a company releases earnings? And more importantly, how do you do it profitably?
Investors gain insight into recent financial performance and future performance when a company releases its earnings. However, there is some uncertainty during that time as well. Investors use the earnings release to indicate how the company will perform in the upcoming quarter.
When next quarter’s earnings are released, investors will gauge that performance against the expectations that had been set three months ago. Even when a company generates a positive number, its stock can still take a significant hit if it doesn’t exceed expectations by beating the estimates.
The market is said to be volatile during earnings season because the market takes last quarter’s earnings predictions into account and assumes the company will meet those predictions. That assumption is factored into the market’s calculation of the stock price.
When the quarter plays out and the company announces whether they actually missed or beat the earnings predictions from last quarter, uncertainty and volatility exist because, upon learning whether predictions were met, investors must process that new information quickly. How the investors react in that short period will trigger upward or downward movement in the stock price.
The investors’ expectations drive what is called implied volatility in the options market.
Implied volatility (IV) is driven by the degree of fluctuation in stock price expected by the investors. So, the higher the expected movement, the higher the IV.
A stock's IV will generally rise as it heads into earnings. Not because the stock is necessarily more or less volatile, but because there is a lot of uncertainty and/or risk around what will happen during the earnings announcement.
When volatility increases, the premium on the option also increases, and everything becomes more expensive.
This one-time event swells option premiums on BOTH sides of the market. For an options trader, this creates an opportunity to sell relatively expensive options and profit from their decline in value.
Conversely, when earnings are released, the market has a relatively better understanding of the company’s future, so uncertainty typically dissipates. The volatility naturally decreases as uncertainty fades. This decrease is called volatility crush (highlighted on the charts with the blue line at the bottom) and lowers an option's price.
Of course, we don’t always see a volatility drop, but in most cases, we’ve researched that IV drops very quickly after the earnings event.
Target options selling strategies
Knowing this fact, we need to focus purely on option strategies in which we are net sellers of options.
We'll focus on three primary strategies around earnings:
Most people who trade options grasp the concept of volatility crush and make trades that take advantage of the volatility. The three strategies above count on two things:
A rangebound stock
When volatility is high, that range can be assumed to be higher than it normally is.
A short straddle strategy is when an investor sells a call option and a put option of the same underlying stock with the same strike price and expiration date. The investor does this when they believe that the stock price will not move significantly during the life of the option contracts.
With short straddles, investors profit from the lack of movement in the stock price. This takes the guesswork out of options trading where investors place directional bets and hope for a big move in stock price either higher or lower.
A short strangle strategy is when an investor sells a put and a call of the same underlying stock with the same expiration date when both of which are slightly OTM.
With short strangles, investors are limited in terms of profit, while risk is unlimited. Investors are willing to accept this risk if the underlying stock is expected to incur very little volatility in the short term.
Short strangles are essentially credit spreads, as a net credit is taken upon making the trade. Profits with a short strangle are maximized when, at the expiration date, the underlying stock price is in between the strike prices of the options being sold. When the options expire, they are worthless, and your profit equals the entire amount of the initial credit.
When an investor enters a short strangle, they sell an OTM put and an OTM call at an equal distance from the current market price. By taking a neutral outlook on the possible move in the stock, we minimize our directional guess of an earnings pop or drop.
It’s important to note that a big bet in one direction during earning season is not the way to go. Instead, if you stay non-directional, you can always adjust later as necessary. Regardless, as long as you stick to selling options with high implied volatility, you should be much better off than buying options around earnings.
If you can’t sell options naked or don’t want to take on the additional margin risk, then you can use our third favorite strategy - the iron condor.
An iron condor involves selling a put, buying a put, selling a call and buying a call.
The investor sells the put and buys another with a lower strike price and sells the call and buys another with a higher strike price. All options have the same expiration date.
Sounds confusing, I know. But you will get the hang of it with a little more information and some practice.
Iron condors result in a credit instead of a debit, so it pays money upfront and creates a range of safety or a virtual safety net. In other words, if the stock price is within that range by expiration, you win.
Exit or roll positions after earnings?
We’ve covered why to trade around earnings and a few strategies to use. Now, let’s briefly talk about managing the position after the stock re-opens post-earnings.
In nearly all cases, you’ll see some gap in the stock price as investors react to the company news.
If the stock stays within the strike prices of your position, you can easily exit the trade and close out the position for a profit. This is the ideal outcome, of course.
But we all know that the market doesn’t always do what we want, right?
So, what do you do if the stock moves outside your strikes and goes ITM? We do have some options (no pun intended).
As you may already know, rolling an option is a way to manage a position by closing the existing position and opening a new one at the same time.
Your first adjustment should be to roll out your option to the next contract month and take in more premium. For example, if you had a December expiration option, you would roll it out to January (at the same strike price) and realize additional credit.
With more time and a higher credit on the overall position, you give yourself more time to profit while also moving your break-even points out further.
One more thing. You can also roll in the other side of the trade that shows a profit. If the stock moves higher, you will roll UP the put side and visa versa on the call side; if the market moves down, you would move DOWN the call side.
These adjustments will give you a higher statistical chance of making money even if the stock moves against you at first.
The release of earnings is a binary event involving significant uncertainty. Initially, this uncertainty triggers IV to spike, and once earnings are announced, IV crashes.
Understanding this central concept will take the guesswork out of options trading and enable investors to move forward, build upon that knowledge and leverage profitable options strategies.