The Art & Options Strategy Behind Quick “Earnings Trades”

In this podcast I want to walk through my strategy for filtering and finding good stocks to trade around earnings and how to set them up, as well as my thoughts on exiting trades shortly after the market opens.
The Art & Options Strategy Behind Quick “Earnings Trades”
Kirk Du Plessis
Apr 24, 2017

We're now in the heart of earnings season for the current quarter and with hundreds of companies set to announce their performance we're presented with tons of opportunities as options traders to profit from the volatility crush that occurs after an announcement. But these fast (and often violent) moves in the underlying stock in the session following the announcement can often scare and confuse investors trading options.

If you've ever wanted to jump in and make some earnings trades, you'll want to tune in and take lots of notes. Don't forget, we've also got a free course and PDF guide to earnings trades available for members inside our education platform.

Key Points from Today's Show:

  • Every quarter, companies announce earnings, which results in an implied volatility crash.
  • Before the company announces earnings, there is a lot of pent-up hype about what might happen as they announce earnings.
  • As you approach earnings even, the implied volatility usually starts to increase; the expectation of a big move is always present before the event.
  • At the moment when the company announces their earnings, the market has to reprice the stock in real time.
  • There is a short duration and timeline of exposure which compresses the entire cycle of IV contraction down into a single moment.
  • The drawback of an earnings trade is that it exponentially increases the learning curve, with limited time to adjust.

Finding Earnings Trades

  • Focus on earnings trades that are coming up the week that you are trading.
  • Pair down your list to focus in on trading the big name securities.
  • Check to see the type of contracts that are available to trade, preferably short in duration and timeline.
  • Shorter contracts have most of the volatility priced into the security and it will react much faster to the earnings announcement.
  • The weekly contracts don't have much time value built in and so they will decay at a much faster rate.
  • Your IV rank has to be above 50 because you want to have a strong drop in IV, which only happens if IV is high to begin with.
  • Make sure there is good liquidity in the weekly options. Weekly contracts are generally less liquid than monthly contracts.
  • You want to see good volume and good open interest the week leading up to earnings varies depending on the security.
  • Make sure there is also good liquidity in the next monthly contract, in order to roll to the next month if adjustments need to be made.

The Expected Move

  • You want to have a good understanding of how far the market thinks the stock is going to move.
  • The market will always expect that the stock moves more than it does long term.
  • However, most of the time the stock will move less than the market expected, long term.

Choosing a Strategy

  • The first thing to look at is implied volatility:
  • If IV rank is in the upper end above 50%, always try to be more aggressive in your strategy selection, doing the straddle or selling the iron butterfly really wide.
  • If IV is 50%-75%, then you can be less aggressive doing more strangles and iron condors.

When to Get Into the Trade

  • Too many traders get into the trade much too early.
  • Often times, leading up to an earnings announcement the stock may have a dramatic move the last day or so.
  • Need to be as neutral to the direction of the stock as humanly possible.
  • The best way to do stay neutral is to trade the options 30 to 45 minutes before the close of the day of or the day before they announce their earnings.

After the Trade

  • Once the company announces earnings, the stock will naturally change in price.
  • This allows you to set up your strategy for exiting or adjusting.
  • If the stock moves within the expected range, shortly after the market opens you want to close your position.
  • If the stock moves more than expected, now you are faced with a situation where you need to adjust.
  • You first want to follow the same adjustment techniques we discussed.
  • You want to adjust by first rolling the tested side out to the next expiration month for a credit, if possible.
  • At the same time, roll out and roll in your untested side:
  • if the stock moves higher than expected, roll up your puts.
  • if the stock moves lower than expected, roll out your puts that are in the money and roll out and down your call side.
  • if the stock is aggressively going against you and is definitely well beyond your breakeven points, you want to start trying to make this adjustment now.

*Caveat: if you can make this adjustment for an overall credit, it is the best way.

  • Having the ability to add more timeline to your trade, more duration for the stock to come back around inside of its range is the best course of action.
  • if you cannot roll that trade out to the next month for a net credit, it's not worth doing.
  • Keep your position sizes small to avoid big potential losses.
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