The time when a company reports earnings is a very important moment for traders. As a company’s earnings report is used to understand the health of a company and determine its value, the release of an earnings report can generate significant volatility as investors and traders change their expectation of the future price of a stock.
Sometimes a company’s earnings will greatly surprise the market, generating extreme volatility. These moments can be highly profitable for traders if they get their forecasts right, but they can also be devastating if their forecast were wrong and they didn’t protect themselves.
Being a good trader means participating in profit opportunities while managing your downside risk well. One way to do this is to use options. In this article we will showcase the best options earnings strategies that you can use to effectively increase your probability of success while protecting your downside risk.
How Company Earnings Affect Options
Before embarking on an options earnings strategy, it’s important to understand how earnings impact the behaviour of options so that you can pick the right strategy for the earnings scenario you have forecast.
As earnings announcements approach, investors become increasingly uncertain of which direction the market will move the stock. Implied volatility is a prediction of the future movement of the stock. If investors expect the movement to be high, implied volatility will also be high.
The way this impacts options is that when volatility increases, so do option premiums. By the same token, when volatility drops (such as after an earnings announcement) option premiums drop as well. By ‘going long’ options, you gain when volatility and option premiums increase, while ‘going short’ options allows you to gain when volatility and option premiums decrease.
The following is a list of the best options earnings strategies, including suggestions on when to use or avoid them.
Strategy 1: The Pre-Earnings Close Out
While most options earnings strategies rely on closing trades after earnings announcements, the pre-earnings closeout takes advantage of volatility increases in the lead up to an earnings announcement.
One of the key benefits of this strategy is that you don’t need to pick the direction of a stock after its earnings announcement because you close out your position before the earnings announcement, you avoid the possibility of any sharp, sudden changes in volatility and option premiums.
To execute the Pre-Earnings Close Out strategy, purchase long calls, long puts or both (called a long straddle) about one to two weeks before earnings and close out your position a day or two before the earnings announcement.
To be effective, use this strategy when you expect the stock to make a big move in the lead up to an earnings announcement. Use a long call if you believe the stock will go up, a long put if you believe it will go down and a long straddle if you don’t want to bet on a direction.
Strategy 2: Shorting the Volatility Drop
Implied volatility generally drops after an earnings announcement is made, provided there are no unexpected extreme shocks. You can profit from the drop in volatility by shorting it.
To execute this strategy, sell short (naked) calls, short (cash secured or naked) puts, or short strangles and straddles just before an earnings announcement is made. Then, as implied volatility decreases after the earnings announcement, you can potentially buy them back at a profit if they’ve lost enough value.
Unlike the Pre-Earnings Close Out strategy, you are exposed to the risk of an earnings surprise which could blow out your position.
Strategy 3: The Big Move
Often when a company reports earnings they differ significantly from analyst estimates, resulting in an earnings surprise. It generally happens because it makes for a better story for management if they can keep expectations low and beat them, or at the very least give themselves wiggle room in case they don’t perform as well as they could have.
As a result of these earnings surprises, stocks will make a significant move up or down. As you may not know or care to forecast which direction the stock will go in, you can capitalise on the large stock move from an earnings surprise with the Big Move strategy.
To execute this strategy, buy a call and a put on the same strike and maturity. This is called a long straddle. This allows you to create a non-directional play so you can profit from a significant up or down move. Enter your position the day before the earnings announcement and exit the position towards the end of the day when earnings are released, to capitalise on the main movement in the stock price.
When entering your position, always go with at-the-money and choose the shortest time to expiration. By doing so, you ensure you profit regardless of the direction of the move and you are positioned to get the most reaction and movement out of the straddle.
In order for this strategy to work, the move needs to be a large one because you are buying two options which raises your breakeven price, where a small move will cost you money. So only use it when you believe there will likely be an earnings surprise.
Conclusion
Earnings announcements provide a fantastic opportunity for traders to make a profit from changes in implied volatility and option premiums.
The three strategies in this article provide you with the opportunity to take advantage of multiple scenarios. You can take volatility bets across both pre and post earnings announcements using the Pre-Earnings Close Out or the Shorting the Volatility Drop strategies, or make a non-directional play with The Big Move.
Be sure to keep in mind the unique characteristics, requirements and risks of each strategy to make sure you apply the right strategy for the particular scenario you are forecasting.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
