By: Steve Smith
Earnings trades can be a trap shoot but there is one predictable pricing behavior 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 a loss despite being “right.”
Don’t Get Post Earnings Premium Crushed
The problem they failed to account for is 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” on 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.
This article does a great job of explaining how to use the straddle to both assess expectations and potentially profit.
For example; back in April Constellation Brands (STZ) closed at $151.50 last and April $120 straddle (the $150 call +$150 put), which the following Friday closed at $9.30, suggesting a 5.3% or $8.20 price move. Note, I adjusted for the fact the options still had 9 days until the 4/15 expiration. On Wednesday morning the wine and beer conglomerate posted a much better than expected earnings line and when the stock opened up it popped $9 to $160 per share. Anyone who bought call options ahead of the report was likely rubbing their hands with glee in anticipation of a huge profit.
But because the implied volatility and hence the premiums get crushed immediately following the event, the profits would have been minimal despite the monster move. This is especially true if you had used the wrong approach. For example, the $160 call was actually down $0.50 from $2.75 prior to the report to $1.25 the following morning. The lesson: don’t buy out-of-the-money options prior to earnings in hopes of hitting a jackpot. These lottery tickets rarely pay-off.
Once option traders are armed with this bit of knowledge, they advance to use spreads to mitigate the impact of PEPC when looking to 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, then 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 preceding earnings, avoiding the actual event altogether. 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 a calendar spread, in which you sell an option that expires prior to the earnings while simultaneously purchasing one expiring after the event. Like any calendar spread it will benefit from the accelerated decay of the nearer dated options sold short. However, this has the added tailwind as earnings approach – the option which includes the earnings will see its 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. More importantly, they can be consistent and have a high probability.
With weekly options there should be plenty of situation in coming weeks to take advantage of the rise in IV leading into earnings. This site provides a good starting point of a list of names and their options specific pricing tendencies.
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.