By: Steve Smith
The past few weeks has seen an increase in broad market volatility as missiles have flown and bombs have been dropped. Now we can expect more on stock specific basis as the incoming wave of quarterly earnings reports begins to wash across the tape just as the debt ceiling fiasco reaches its denouement.
But for now, let’s put aside the politics, and focus on the earnings reports. For some active traders, these jolts of information and the accompanying stock price movements represent terrific short-term money-making opportunities.
We had some banks such as JPM and WFC report last week, but things really get going in earnest when Netflix (NFLX) reports after the close today. As you can see from the table below it is historically the most volatile of the large caps.
Many traders will try to juice the returns by using options – but there’s a right way and a wrong way.
Before getting to some of the concepts and strategies that can be employed in playing earnings, let me provide a caveat: All earnings plays are extremely speculative and should involve a minimal allocation of risk capital.
The challenge in trading earnings is there are many variables that need to be accounted for and correctly forecast.
Not only must you decide if the company will meet estimates (and whether those estimates recently been lowered or raised) and what kind of guidance will be provided, but you also must determine what has already been priced into the stock.
And most importantly for our purposes, you must determine what percentage price move the options are pricing in as measured by their implied volatility (IV). While some services such as Bloomberg provide that data, one can perform the calculations 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. Remember, the options only estimate the magnitude, not the direction of the price move.
Many stocks now have weekly options listed during the earnings report period, which means the time premium will be minimal.
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.
This article does a great job of explaining how to use the straddle to both assess expectations and potentially profit.
Once option traders are armed with this bit of knowledge they to 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, 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 a calendar spread, in which you sell an option expiring 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. But this has added tailwind, because 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.
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.