By: Steve Smith
Earnings season is indeed upon us, meaning I’ll be leading another Earnings360 quarterly program! The first trade recommendations will be issued next week, and I expect to make about 30 trades during an action-packed six weeks of earnings announcements.
To learn all about my unique and time-tested approach to trading these volatile events, join me for my exclusive live event on Thursday, January 14 at 6:00 PM ET/3:00 PM PT.
During this live event, I’ll explain my process and reveal the strategies that have lead to the Earnings360 service producing consistent profits for 13 consecutive quarters.
Honestly speaking, even under the best of circumstances, earnings can be very tricky to trade, being that there are many moving and unknown parts. Will the company miss or beat expectations? What will be the guidance? Will traders “sell the news,” or buy into the unknown believing the recent decline has priced in a near-worst-case scenario?
However, there’s one predictable pricing behavior that savvy option traders use to produce steady profits. Given all the recent volatility, and numerous unknowns, options premiums will be at record-high levels as market-makers need to price options for outsized moves.
So, how do you trade earnings in a world without guidance? Here’s a quick guide that rests on taking an options-centric approach.
Use the Post Earnings Premium Crushed
The one reliable item is that no matter what a company reports, or how the stock reacts, the options will undergo a Post Earnings Premium Crush (PEPC) which is my label for how implied volatility contracts immediately follow the report no matter what the stock does.
As you can see, the repeating pattern of implied volatility of Netflix (NFLX) options are spiking and retreating on the quarterly reports.
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 expected move magnitude is to add up the at-the-money straddle.
This article does a great job of explaining how to use the straddle to assess expectations and potentially profit.
Once option traders are armed with this bit of knowledge, they advance to using spreads to mitigate the PEPC’s impact 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, then the move’s magnitude.
All Earnings360 trades use some form of a spread to give us a high probability of profit while assuming a limited risk.
The Pre-Earnings Trade
True professionals pursue a safer and more reliable positioning path in anticipation of the implied volatility increase that precedes earnings and avoids the actual event altogether. Just as PEPC’s predictable, so is the premium pump-up leading into the event. It’s just more subtle because it occurs incrementally over many days.
One strategy for capitalizing on rising IV leading into earnings is a calendar spread where you sell an option that expires prior to the earnings while simultaneously purchasing one that expires after the event.
Like any calendar spread, it’ll benefit from the accelerated decay of the nearer-dated options sold short. But this has the added tailwind of as earnings approach, the option which includes the earnings, will see IV rise, causing the spread value to increase. To keep the position delta neutral, the put and call calendars should be established.
These positions must be established in advance and closed before the actual earnings. The profits may not be as dramatic as catching a huge post-earnings move. However, they can be substantial. More importantly, they can be consistent and have a high probability.
With weekly options, there should be plenty of situations in the coming weeks to take advantage of the rise in IV leading into earnings. This site provides a good starting point for a list of names and their options-specific pricing tendencies.
With most offering weekly options, there should be plenty of opportunities for double calendars.