Options Trading: How to Handle Earnings Reports
By: Steve Smith
Earnings season has officially kicked off with some of the big banks such as JP Morgan (JPM) and Citi set to report this coming Friday morning. This is an important, yet difficult time for options trading.
Earnings can be very tricky to trade as there are many moving and unknown parts; will the company miss or beat expectations, what will be the guidance, will traders ‘sell the news’ in profit taking and will the recent overall market volatility override the results.
But there is one predictable pricing behavior that can produce steady profits through savvy options trading.
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 “right.”
Don’t Get Post-Earnings Premium Crushed
The problem is they failed to account for the Post-Earnings Premium Crush (PEPC) which is my label for 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” o 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 t 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.
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.
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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.
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