By: Steve Smith
Earnings season has officially kicked off this morning with some of the big banks such as JP Morgan (JPM) and Wells Fargo (WFC) reported mostly better than expected numbers. Yet shares are moving lower, which shows trading earnings can be something of a crap shoot. But there is one predictable pricing behavior that savvy options trading can use to produce steady profits.
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 the right call.
Don’t Get Post-Earnings Premium Crushed
The problem is they failed to account for the Post Earnings Premium Crush (PEPC), which I discussed in this article describing how the 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” of 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 tend to advance to using 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 options trading strategies still carry the risk of trying to predict if not the direction, than the magnitude of the move.
Here’s a list of the historically most volatile stocks following earnings reports. Which means they are likely to see both the largest increase in implied volatility leading up to earnings, and the largest PEPC.
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 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 effect, where as earnings approach the option which includes them 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 still be substantial. More importantly, they can be consistent and have a high probability.
With weekly options, there should be plenty of situations 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 of opportunities for double calendar options trading. As always, do your own research and confirm the reporting dates, but this offers a great starting point.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.