SESSION FIFTEEN EARNINGS PLAYS
Basic Principles Behind Earnings Plays • Stocks typically, but not always, will move the first trading day following earnings, more than the average move for that stock over one trading session. • Recognizing this, the options market will drive up the Implied Volatilities of that stock’s options in the days leading up to the earnings event. • The IV’s in turn will almost always drop, sometimes precipitously, almost immediately after earnings have been announced and the market has digested the company’s results. • Normally the front month volatilities will drop more than the back month volatilities. The overall drop in volatilities of all options for all months as well as the the relative drops between months all have ramifications depending on the trade that is selected for that stock before that particular earnings event.
Earnings Plays • If the trader believes that the IV drop will be so strong that the price movement will be overcome by the IV drop (i.e. the delta effect will be less than the vega effect) then you can SELL a straddle (iron butterfly or calendar) or sell a strangle (iron condor, double diagonal or double calendar). • If the trader believes that the price movement will be so strong that the price-suppressing effects of the IV drop will be overcome by the price movement effect, then the trader will BUY the straddle or the strangle. • Note—we never allow our risk to be unlimited so we will always buy wings for our short straddles or short strangles.
IV drop, even with big price move, causes large profit after 1 hour of trading
AAPL Price Chart one day before earnings announcement, October, 2010
Heightened IVs of AAPL approaching October 2010 earnings release
ATM straddle sold in front month/bought in back month—note elevated front month vols
Morning after earning release, 13% gain despite large move=monster vol drop in front month vs. mild drop in back month.
Selling front month strangle, buying back month strangle=the double calendar
Long Straddles • Some traders like to play long straddles when they believe the market is underestimating the likely price move as a result of the earnings release. This can be very rewarding, but also very difficult as the vol crush must be overcome by a monster price movement to compensate. If a long straddle is in fact chosen, the trader should carefully study previous quarters to see whether in fact the delta change was significant enough to overcome the vol crush.
Homework • Using the Optionvuebacktrader module, select four stocks from the past five years and observe the way their front month and back ATM options behave right before and right after earnings are announced. Then construct either a butterfly, condor, calendar or double calendar trade that suits the pattern of the behavior of the options relative to that equity. Review at least four quarters of data before making a selection. Once the selection is made, place the trade selected and document the type of trade made and the results for each