In this video tutorial, we want to talk about the different earnings options strategies that you can use. Remember, when we’re looking to trade options around earnings, we’re specifically targeting that IV drop or IV crush that happens, and that’s just a refresher.
When a company announces earnings, we typically see a run-up in implied volatility ahead of that earnings announcement because of the unknown that’s coming with earnings. Are they going to grow? Are they going to be cutting jobs? Are they shutting down?
What’s happening with the company? We don’t know. And implied volatility expands which means that option pricing swells across the board and what we get is that we get an IV drop that happens dramatically after the company announces earnings, whether that’s the day after or the next day, we get it pretty soon afterward. That’s what we’re targeting.
Here’s a quick IV drop example. This is a stock that we just recently traded as of the time of this video. You can see that every time that it has earnings in these red circles, every time that it announces earnings, regardless of where the stock goes, we see a huge drop in implied volatility which is that green line on the bottom and it happens very dramatic.
In this case with this stock, implied volatility goes from about 35% down to about 20% or 15% very, very quickly. That's what we’re targeting, that almost assurance of that drop in implied volatility.
Therefore, we want to focus on strategies that take advantage of this drop in implied volatility. This is where people get it wrong with earnings trades, are they don't focus on just trying to take advantage purely of that IV drop.
This means that we would need to be net sellers of options wherever possible. Here are some of the best strategies in order of how we like to trade them. The first one that we always like to trade is a short straddle or a short strangle. This is a short straddle.
Basically what you’d be doing is selling the at the money options that are closest to where the stock is trading right now, you take in a very, very big credit which is a big healthy credit, you are undefined on both sides, but that big credit that you take in helps move your breakeven points further and further away from where the stock is trading.
Ideally, what you’d want to do is trade a short straddle when there’s not a lot of premium on the further out legs of an earnings trade.
If an earnings trade doesn't have a lot of liquidity and market basis outside of just those closer in options, you might want to choose to do a short straddle and take in a lot of premium because it's available. The next best thing that we'll try to do if we don't want to do a straddle is to do a strangle.
We would go further out of the money on either side of the market and sell a call option that's far above the market and a put option that’s far below, try to be as even as possible and we try to get outside of that expected range that we’ve already talked about, about making sure that we’re trading a high probability setup here with earnings.
The two previous examples, both the straddle and the strangle are undefined risk trades, meaning you’d have to carry the margin to hold those positions. For some accounts, that may not be possible, or if you have a smaller account, you may not want to carry the margin, so the next best thing is to do an iron condor.
It’s the same short strikes that we had here above with the strangle, so same short strikes, but now we’ve added protection on either side.
This does reduce your overall potential profit because you have to buy those extra legs or those other sides of the trade, but this also gives you the ability to do the trade while putting up a little bit less capital in the process.
Let’s look at a live example for possible trading setups and then the profit and risk numbers behind each of the different strategies that we talked about.
Alright, you can see here we’re on my Thinkorswim platform and what we’re going to look at today is SLB. This is a stock that we’ve traded a couple of times before. We like SLB. We’ve been profitable trading this thing.
You can see that it does have earnings that are coming up tomorrow or actually, after today after the close. This is about 11:30 in the morning that we’re doing this call right now and you can see that it's got earnings that are coming up tomorrow, the conference call is tomorrow, and the earnings are going to be announced right after the close today.
This is the ideal time that you’d be wanting to get into an earnings trade. When we get into the trade tab, the first thing you’ll notice is we are trading the front most contracts. In this case, this is the January contracts that we’re trading because there are no weeklies available.
We’re in expiration week, so the monthly contracts act as the January contracts in this case. But usually, you’d be trading a weekly option or whatever is closest.
You'll notice these January contracts only have one day of expiration, but given that they only have one day of expiration, look how much volume and open interest are in these contracts.
There’s a lot of liquidity in this market, and it makes it a good trading setup. The other thing that we want to quickly take a look at is the expected move.
In Thinkorswim, they’re good because they throw in here the expected move which is about 3.80, so we’re going to round up and give ourselves a little bit of room and say that we think that the stock might move about $4 in either direction after earnings or probably inside of that range about 70% of the time.
What we’re going to do is we're going to try to (with our strangle and iron condor) move outside of that range with our short strikes. But let’s first look at trading the at the money straddle.
The closest at the money straddle to this current stock price is the 77s, so we’re going to go here to 77s and sell a straddle. Alright, now you can see here we take a $400 credit, a very big credit.
Even though we’re selling options that right at the money, we’re taking in a very nice large credit here. We do have that undefined risk feature but don’t worry because there is defined risk here in the sense that we only have to put up about 15.45 in the margin to hold this position.
As you can see, that $4 credit moves us about $4 outside of the expected range. That $4 credit that we have here moved us about $4 on either end, so our new breakeven prices are 73 and 81 which gets us just outside of that range on either side.
That’s the point of the straddle, is that it's a lot more capital intensive to do this position, but you take in a bigger credit, so if the stock doesn't move and has a big drop in implied volatility, you have a much, much bigger profit potential.
Alright, but let’s say that we don’t want to do the straddle. It’s just maybe a little bit too risky for you, or you don’t feel comfortable doing it. The next best strategy we can choose is to do a strangle. In this case, what we’re going to want to do is pick strike prices that move us outside of this $4 range.
We’re going to go down below the market $4 which would be about 73 or so, and we’re going to move to the 73 strikes on the bottom side which are right here and on the top side, we’re going to move to about the 81 strikes which are right about here.
We’re going to move to the 81 strikes and about the 73 strikes to get us an equal distance away from the market. If I go here and right click on these 73 options and go down to the strangle, and then all I have to do here is move up my call side to the 81s.
Okay, now we’ve done the 81 and the 73 which we've talked about here, so these two options, the 81 and the 73, what’s great about this is that we take in another big credit of $1.22, so not as big as the straddle, but that $1.22 helps move our breakeven point out even further.
That $1.22 gets added and subtracted to each side, and you can see our new breakeven point is 71.78 below the market and 22 above the market well outside of this expected range here.
Sometimes you don’t have to go just outside of the expected range with your strike prices, but that credit that you take in is enough to move you outside of that range and get you beyond that area.
Now, if we wanted to, instead of this, we’ll just leave up these same short strikes, instead of doing the straddle or strangle, we wanted to do the iron condor, we could buy legs on either end of the trade.
All I’m going to do here and as a quick little tip, but you can hold down the control or function on your keyboard and just add legs. We’re going to add the 82 leg which is beyond the 81, and we’re going to add the 72 leg which is beyond the 73.
Now you can see we’ve added protection here in this trade by adding a long call at 82 and also by adding a long put at 72. That adds protection, but notice how that dramatically reduces the credit that we received on the trade.
Now we’re only getting about $32. This is a risk defined trade, and in this case, the most you can lose on this trade is about $73 with commissions, and our max profit is about $32.
It’s still a good risk reward, you’re still making some good money on this trade, but you’ll notice that if you trade it risk defined, you do have a lot less risk, but you’re also going to make a lot less money.
This is a great example of using all three of the different strategies that we’ve chosen, and in this case with SLB, you can use any of the three strategies that we've chosen.
The markets are very liquid, they’re very wide, and all of them gets you outside of that expected range that the stock is trading at. Hopefully, this has been a really good example of how we can use different strategies for earnings trades.
As always, if you have any questions or comments, please add them right below this video. Until next time, happy trading!