By: Steve Smith
Earnings trades can be trap shoot but there is one predictable pricing behavior that savvy option trader use to produce steady profits.
We’re heading into earnings season and many people choose to use options to play these high risk/reward situations. The biggest mistake novices make is purchasing puts or calls outright as a means of directional “bet”. They are usually disappointed with the results as even if the stock moves in the predicted direction the value of the option can actually decline and result in loss despite being “right”.
Don’t Get Post Earnings Premium Crushed
The problem is they failed to account for the post earnings premium crush (PEPC) in which implied volatility contracts sharply immediately following the report no matter what the stock does. You’ll often hear traders cite what percentage move options are “pricing in” the earnings. The quick back of the envelope calculation for gauging the magnitude of the expected move is to add up the at-the-money straddle.
For example; last Thursday Constellation Brands (STZ) closed at $119.20 last and its $120 straddle (the $120 call +$120 put) closed at $5.20 suggesting a 4% or $4.70 price move. Note, I adjusted for the fact the options still had 7 days until the 4/17 expiration. On Friday morning the wine and beer conglomerate posted in line earnings and the stock opened up just $1 to $120.20. Option premium were crushed; the $120 call was actually down $1 and the straddle was worth just $3, a $2.20 or 42% devaluation.
Once option traders are armed with this bit of knowledge they to advance to use spreads to mitigate the impact of PEPC when looking t make a directional bet. Some will graduate to getting this predictable pricing behavior in their favor by selling premium via strangles or the more sensible limited risk iron condors. But these strategies still carry the risk of trying to predict if not the direction, than the magnitude of the move.
The Pre-Earnings Trade
The true professionals pursue a safer and more reliable path of positioning in anticipation of the increase in implied volatility that precedes earnings and avoids the actual event all together. Just as PEPC is predictable so is the pumping up of premium leading into the event; it’s just more subtle in that it occurs incrementally over the course of many days.
One strategy for taking advantage of rising IV leading into earnings is calendar spread in which you sell an option that expires prior to the earnings while simultaneously purchasing one that expires after the event. Like any calendar spread it will benefit from the accelerated decay of the nearer dated options sold short. But this has the added tailwind of as earnings approach the option which includes the earnings will see it IV rise causing the value of the spread to increase. To keep the position delta neutral both put and call calendars should be established. These positions must be established in advance and closed before the actual earnings.
The profits might not be as dramatic as catching a huge post earnings move but they can be substantial. Last week I was double calendar in Facebook (FB) by selling options that expired 4/17 and buying the 4/24 expiration but it seemed unclear on what their exact earnings date might be. When the company confirmed its earnings would be released April 22nd, it caused an immediate shift in the IV skew as the premiums for the options that would capture the event got pumped up. Without the underlying share price in moving the double calendar went from $1.55 to $2.40 overnight.
Now this is a somewhat unusual situation in that apparently FB’s exact earnings date was uncertain. But it illustrates the power of how the shift in IV leading to the event can be used to your advantage.
I could have just as easily been caught on the wrong side in Google (GOOGL) earnings release. Google had traditionally reported on the Thursday prior to third Friday monthly expiration cycle meaning initial expectations were for April 16th. I know this as it was one of the only big beta names that offered the one day window for doing low cost butterfly spreads. But apparently the new CFO goes by his own schedule, not the options calendar and it will report on April 23rd . When the date was confirmed it caused the IV in Week4 options expiring 4/24 to jump to 29% while the IV for those expiring this week contracted down to 17%. If I had set up position long this week’s options it would have been crushed without the stock having moved much.
Anyway, with weekly options there should be plenty of situation in coming weeks to take advantage of the rise in IV leading into earnings. This article provides a great list of names and their options specific pricing tendencies. The table is attached below.
The key column is IV Est/Now in column 11 is the ratio of the estimated implied volatility to the current implied volatility based primarily on the high reached the previous quarter. Those with higher ratios have a potentially greater opportunity to increase going into their next report date and many have already started increasing anticipating the next report.
With most offering weekly options there should be plenty opportunities for double calendars. As always, do your own research and confirm the reporting dates but this offers a great starting point.