By: Steve Smith
The wave of quarterly earnings reports is hitting a peak with the busiest week of the season – no fewer than 990 companies, 97 of which are part of S&P 500, will be reporting over the next five days. For some active traders these jolts of information and the accompanying stock price movement represent terrific short-term money making opportunities, and many will try to juice the returns by using options.
Before getting some of the concepts and strategies that can be employed in playing earnings reports let me provide the caveat all earnings plays are extremely speculative and should only involve a minimal allocation of risk capital. The challenge trading earnings is there are many variables that need to be accounted for and correctly forecast.
Not only must you determine if the company will meet estimates (and if those estimates have recently been lowered or raised) and what kind of guidance will be provided, but also what has already been priced into the stock, for example, has it recently run up or sold off. Most importantly for our purpose, what percentage price move the options are pricing in as measured by their implied volatility.
Imagine the game of “what is baked in” to Apple’s (AAPL) earnings on May 2, with the ingredients of its recent rally from $120 to $145 following its last earnings report, the speculation surrounding any new products, to iPhone 7 sales slowdown in China. I expect the implied volatility for Apple options, which have already increased by 21% to the 27% over the past two weeks, to hit the mid 30s by next week. Then no matter what the results or response, expect implied volatility to decline back towards the mid-20s level following the event.
Prepare for Post Earnings Premium Crush
This tendency for a post earnings premium crush (PEPC) make understanding the relative “expensiveness” of options and the magnitude of the price move being priced in crucial to improving the probability of achieving a profitable trade.
On face value Google’s (GOOGL) options, which reports this Thursday, with an implied volatility of around 30%, appear cheaper than Apple’s, but when looked at relative to each stock’s 30 day realized or historical volatility (HV), Google is actually more expensive. Google’s HV is 16%, meaning the options IV are running a near 90% premium compared to Apple’s HV, which is 22%, meaning its options are “only” a 45% premium. But again, monitor whether Apple’s options IV creep higher heading into earnings. A great free site for tracking options volatility, both historical and implied, is iVolatlity.com.
For the reason most options are going to see a decline in implied volatility following the report, it is wise to use a spread rather than the outright purchase of options in making a directional bet. The next step is using the implied volatility level to determine what size price move is being estimated or priced into the options. This will help you determine which strike prices you might want to use in setting up your position. Some premium sites provide that data one can perform the calculation relatively easily. The down and dirty formula would be to simply take the price of the at-the-money straddle, that is, add the price of the puts and calls and divide that total by the price of the underlying shares.
For example, with Google trading around $875, the April $835 calls are trading at $13 and the $875 puts are trading at $13, giving the straddle a value of $26. This means the options are pricing in at around a 2.9% price move. That is $26/875=2.9. Remember, the options only estimate the magnitude, not the direction of the price move.
Note we are using the weekly options expiring this Friday, which makes this calculation much easier, in that time decay is a minimal factor given their will be only one day until expiration. This means the option will essentially go to intrinsic value. However, if we look at the November options expiring in 31 days, the straddle is valued at $38. But note after the earnings report these options will still have 29 days of time premium, which would amount to around $12 in the straddle.
Given most of the popular issues will have weekly options listed for their earnings reports, it would make sense for those looking for the speculative action of earnings plays to stick with the leverage of these short-term contracts. But remember this leverage cuts both ways; if you are wrong expect to lose 100% of your allocated capital.