By: Steve Smith
All the political and policy noise is about to brushed aside by what really matter for stock prices; earnings. The calendar has shifted a bit over the years and now the season kicks off with big banks such JP Morgan (JPM) and Wells Fargo (WFC) reporting this Friday. And then the floodgates open, peaking during the first week of August when over 1500 companies face the quarterly firing line.
For some active traders these jolts of information and the accompanying stock price movement represent terrific short term money making opportunities. Many will try to juice the returns by using options.
Before getting to some of the concepts and strategies that can be employed in playing earnings reports, let me provide the caveat that all earnings plays are extremely speculative and should only involve a minimal allocation of risk capital. The challenge with trading earnings is there are many variables that need to accounted for and correctly forecast.
Not only must you determine if the company will meet estimates (and whether 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, including if it has recently run up or sold off. Most importantly for our purposes, what percentage price move the options are pricing in as measured by their implied volatility.
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.
For a great visual look at how Netflix’s (NFLX) historical volatility versus its implied volatility diverges then converges before and after earnings reports.
Netflix options usually ‘prices in’ a 10% price move. Meaning if you just buy options outright, whether puts or calls, and the stock moves less than the expected 10% move, you lose.
Expensive is Relative
On face value Google’s (GOOGL), which reports July 24th, options with an implied volatility of around 30% appear “cheaper” than Apples, but when looked at relative to each stocks 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 Apples 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.
Because most options 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 that 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. While some use services such as Bloomberg, other premium sites provide the data one can perform the calculation with relatively easily. The down and dirty formula would be to simply take the price of the at-the-money straddle, by adding the price of the puts and calls, and dividing the total by the price of the underlying shares.
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 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.
I’ll drill down into some specific earnings options trades, which use PEPC in our favor, as the season plays out.