Trading options earnings announcements and stock
Earnings season is upon us but what does that mean? In my experience, many traders are caught off-guard each time earnings reports start hitting the street because they are often accompanied by unexpected volatility in their stocks.
An earnings report is relatively easy to anticipate, are publicly accessible and are one of the ways that traders can find out more about the company they are interested in. Plus, as you will see in the video on Using Options to Trade Earnings, earnings announcements provide a great option trading opportunity. An earnings report is provided by a public company four times per year and summarizes performance, strategy and corporate changes that have taken place over the last 3 months.
The quarterly report is usually accompanied by an earnings conference call streamed over the internet and often includes a PowerPoint presentation to summarize the highlights. Typically, earnings reports are released in the month following the end of the last fiscal quarter. That means that mid January, April, July and October is a quarterly earnings season with large groups of stocks reporting results each day for a couple weeks. That increased flow of information coming from each company creates some fast price movement.
The volatility that accompanies an earnings report can be disruptive to some investors because it is not uncommon for prices to gap just following the news release in between market sessions. On average, the direction of the gap following an earnings release is not very predictive, especially over the long term.
However, the volatility that occurs after the release can still be turned into an interesting options trading opportunity. A popular way to take advantage of the possibility for large price moves on an earnings announcement is to trade option straddles or strangles. These can be a lot of fun to trade and are very easy to setup. You can find more information about creating and entering an option straddle here.
An options straddle is a speculative position in which you take a neutral stance on the market or stock by buying a call and a put. That way, if the market moves a lot, one of those options will become quite valuable and will make up for the losses in the other position. Traders using these strategies have to get used to long periods of small losses interrupted by a few very large moves. If you are interested in trying a few straddles on your own, find a few upcoming earnings reports and paper trade a few straddles yourself.
The concept is to buy an option, just before the earnings announcement, that will expire at the end of the week after the announcement. Since the reaction to an earnings announcement takes only a day or two the holding period for the option can be very short with almost zero time decay in the option price.
The entire option price change will be dominated by the reaction to the earnings announcement. To further reduce the cost of the investment the option should be purchased slightly out-of-the-money OTM. Before we go into the detailed steps and stock selection parameters for this strategy let us take a quick look at a recent example.
If this pattern were to repeat, the upcoming earnings announcement at the close of April 27, might be a candidate for this strategy. In general there is often a rise in Implied Volatility IV just before earnings are announced, which is then followed by a volatility crush return to normal levels after the announcement. Therefore, the stock price change needs to be enough to overcome the lowering of the implied volatility and the lowering of the option premium.
In the FB case, IV increased from. Screening parameters used in PowerOptions to find potential candidates for this strategy.