What is an earnings trade and why should I care?
Earnings trades are generally one to two day trading events where a company announces earnings and we generally see a quick and rapid decline in implied volatility. This means that the option prices are generally very high heading into an earnings trading event and then quickly decay in value following the announcement regardless of where the stock moves. As an options trader, this gives us a unique opportunity every four quarters to selectively trade stocks which have high implied volatility and show a history of seeing an earnings contraction or implied volatility crush after the announcement. This basically takes the entire trading timeline and compresses it down to a one day event which gives us a great opportunity to increase the number of trades that we have while streamlining our probabilities overtime. We do not suggest that all new traders follow these earnings trades until you've seen some of them come across for a month or two and understand how quickly they move. Again, this is a compressed timeline and is a great opportunity to learn, but also might scare away some new traders. It's important that you trade all earnings trades neutral and keep your risk size and trade allocation low and manageable because stocks will move quickly in some cases. When this happens, we do not want you to be a position that is too much to handle or exceeds our posted risk allocation guidelines.
Does implied volatility expand or contract as we get closer to earnings?
In most cases implied volatility will expand as we get closer to earnings because of the one time binary event and unknown company announcement that follows. The more unsure the market is of the possible announcement being either dramatically good or bad for earnings, the higher the implied volatility and option pricing will be to reflect the additional fear or greed in the market. Some stocks will peak in IV the day before earnings while others might peak a week or two before the announcement. For this reason, we choose not to trade the possible increasing IV setup with long options because we are not confident it will always happen. On the other hand, we are confident of the quick and rapid drop in IV that occurs after the company announces earnings and have market data to prove that this setup is a higher probability trade.
What is the best strategy for an earnings trade?
Because earnings events are a one time binary announcements, they are usually followed by a volatility crush where implied volatility drops dramatically after the earnings announcement. Therefore the best options strategy to take advantage of this IV drop is to trade either a short strangle, straddle, or iron condor. These option strategies are specifically designed to take advantage and profit from an implied volatility drop and also give you an opportunity to place the earnings event with a neutral bias.
What time frame should I use for an earnings trade?
Again because earnings trades are 1 day events, short timeline and duration is the best choice. As a result the closest weekly option we can find will be your best contract to trade. If the underlying stock does not have any weekly options available then you are okay to go out to the next contract month. Weekly options however give you the best opportunity for a quick decay in the option’s value following the announcement and the best opportunity to generate a profit.
How do I figure out the expected move of an earnings trade?
To figure out how far a stock might move up or down after earnings (70% of the time) you'll want to take the price of the ATM straddle of the closest weekly options contracts and multiple that number by 70%. Then take your answer and divided it by the stock price. For example, if a stock is trading at $50 and the ATM straddle is trading for $2.25 then we would take $2.25 X 70% = $1.575 / $50 = 3.15% expected move up or down. We also post expected move calculations for you as part of the Option Alpha watch list so you don’t have to worry about calculating it if you don’t want to.
How do I select the strike prices on an earnings trade?
There are a couple different ways to select strike prices on earnings trades. The first way, and our personal strategy at Option Alpha, is to short both the call and put options that are one standard deviation away from the current price of the stock. These would be at the 15% probability of ITM level. The other way is to find out what the expected move of the stock is after earnings (say $5 in either direction up or down) and make sure that your short options on either side are just outside this range, maybe $6 away on either end. Again, this will get you about a 70% chance of success during the earnings event.
How do I determine my break-even points on an earnings trade?
For most earnings trades that are short premium strategies like strangles or iron condors you will determine your break-even prices the same way you would otherwise. Take the premium or credit received from selling all the options and add or subtract that from your short strikes. For example, if you took in a .50 credit on a strangle by selling the $40 put strike and the $60 call strike you would have break-even points of $39.50 and $60.50, respectively.
What happens if my earnings trade goes against me?
If you're trading these strategies correctly more than 70% of the time you will have winners but there will always be trades that go against you. Your first line of defense if an earnings trade goes against you is to roll up the side of the trade that the market moved away from. For example, if the stock gaps higher then you would roll up the put side of your trade to a level closer to the new market price after the event. Doing this will allow you to take in a bigger credit which will widen out your break-even points. If the stock continues to move against you during your short expiration cycle and you want to continue to hold the position, then your next adjustment would be to roll the entire strategy out to the next monthly contract for a credit if possible. This will add even more premium to widen out your break even points, but more importantly it will give you more time for the stock to settle into your expected range.
Should I roll my earnings trade from the weeklies to the monthlies?
Yes. If the stocks moves against your position after the earnings announcement one strategy to adjust the position and give yourself more time to be right is to roll the entire position out to the next monthly contract cycle. If the stock opens inside your expected range then you would want to close out the trade and take whatever profit is available that day.
If I expect a stock to have a big move after earnings should I buy a strange or straddle?
No. Because implied volatility generally rises ahead of earnings it is already high and therefore buying options means that you are buying with no theoretical edge in your favor and likely over paying for those contracts. As soon as the earnings event happens, regardless of how far the stock gaps up or down, the value of the options will drop because of the drop in implied volatility. You are much better off to deploy a short strangle or short straddle strategy and target the IV crush as a way to generate a profit without having to worry about the directional move of the stock following the announcement.