Earlier this week, I told you that traders are always looking to “be on the right side of the trade.”
To an options trader, this means you want to be long calls on a stock that is going up in price or long puts when a stock is going down in price.
That’s often easier said than done – take earnings season. Options premiums can fluctuate significantly going into an earnings announcement… and things can really get wild when the announcement is made and the stock price moves on the news.
The challenge, of course, is figuring out how to end up on the right side of the trade.
If the company’s report comes in and is favorable, the stock will usually gap up and open higher than it closed the day before. If you had long call options, then you were on the right side of the trade.
If earnings come in below expectations, the stock will usually gap down and open lower than the previous day’s close. In this case, long put options would put you on the right side of the trade.
That said, it can be quite difficult to judge which way a stock will move on an earnings announcement (these gaps can be pretty significant – ask anyone who has seen what The Priceline Group Inc. (NASDAQ:PCLN) or Alphabet Inc. (NASDAQ:GOOG) has done the day after their earnings announcements. While good news usually brings a pop and bad news usually signals a decline in the price of the underlying, that’s not always the case in today’s markets.
But what if I told you that can trade during earnings season without having to guess which way a stock will move?
There’s one strategy that can help you profit no matter what happens during earnings season.
Let me show you…
Challenge #1: Calls or Puts?
Here are four scenarios that can – and do – play out following an earnings announcements:
- The company beat earnings expectations, but lowered their forecast for sales/earnings in the upcoming quarters, and instead of gapping up, the stock instead gaps down and or continues to decline in price.
- The company missed earnings expectations, but they reported higher than expected growth in upcoming quarters and the stock gaps up and/or continues to trade higher.
- The company beat earnings from last quarter, but not by this quarters “expected” amount. The beat looks like they are doing better than last quarter, but since it wasn’t ‘good enough’ the stock trades down.
- The company missed earnings from last quarter, but didn’t miss by as much as this quarters “expected” amount. They still have negative earnings, but they are deemed to be doing better than expected by not losing as much, so things are deemed moving in the right direction and the stock trades higher.
All of these scenarios – where good news is seen as bad and bad news is seen as good – can make trading options – buying the “right” options – a frustrating experience for traders.
Strategy: The Straddle
The best way to avoid the frustration of guessing which way a stock is going to move on an earnings announcement is to employ one of my favorite strategies: the straddle.
With a straddle you do not have the pressure of having to pick which option you have to buy in order to make money.
If you buy calls only, the stock has to go higher; if you buy puts only the stock has to go lower. But a straddle allows traders to potentially benefit whether the stock goes higher or lower.
A straddle allows you to take a number of variables out of the equation, questions like: will the company beat, miss, raise guidance, announce a stock buyback program, forecast better or worse results in ensuing quarters… the list goes on.
Any of those can happen – and with a straddle, you don’t care because you are now in position to potentially benefit.
A straddle is an option trade position where you buy-to-open BOTH a call and a put option on the same stock with the same strike price and the same month’s expiration.You are incurring more cost by buying both options, so you need the underlying to make a significant move. And by significant I mean the underlying should have the possibility to a big enough price move to cover the cost of the trade.
For more on this great non-directional trading strategy, click here.
Challenge #2: When to Close Down Your Straddle
Once you’ve decided to use the straddle, the question becomes: do you close out your trade prior to the earnings announcement or hold it until after the announcement?
Before we get to that, let me briefly discuss the concern about Implied Volatility (IV) around earnings.
IV tends to increase going into an earnings report as the speculation of what the report will mean to the stock price going forward increases.
Buyers of options, even the straddle trader, have to be careful and know they are buying higher IV in their options prices during the period before an earnings announcement. It becomes a situation where one is likely to be buying at a high IV to sell at an even higher IV.
Take a look at the image below, which depicts what can happen to IV going into earnings:
The below image shows a spike in IV in the options of a company coming up on their earnings:
The risk in buying ahead of the earnings announcement is the fact the IV is likely to be higher. Once the announcement is made and the news is out, there is no more speculation, and IV heads lower.
Implied volatility comes out of the options pricing, and despite what happens with the price of the stock, “IV crush” can affect the option value negatively. This shows what happens to IV when people “buy the rumor, sell the news.”
Closing before the announcement – The biggest consideration in closing down your straddle before an earnings announcement is that you risk the stock actually gapping or moving enough on good or bad news, and you miss out on those profits if you would have if you held over the announcement.
That is the risk of opportunity lost.
Closing the day after the announcement – This becomes a situation where you may have profit in the trade as the stock has run up and implied volatility is increasing, which pumps up the premium, increasing the call option side of the straddle.
The risk here is that, following the announcement, any of the four scenarios I mentioned earlier can happen – and wreak havoc on your options. The stock might gap in the opposite direction, bringing the options value back to where you started.
Even though a breakeven situation is better than a loss, having the stock come back to where it was when you put on the trade is frustrating.
In addition to the depreciation in implied volatility, a loss of time value may adversely affect the option if the intrinsic value isn’t offsetting that and maintaining or gaining profitability.
The primary thing that can hurt you in a straddle position is if the stock trades sideways or doesn’t move enough to cover the cost of the trade.
When the stock is not gaining any more intrinsic value, the other conditions just mentioned – “IV crush” and Theta or Time decay – can kill the value on that option.
Know Your History
If you’re trading options during earnings season, it’s best to know the historical price moves of the underlying before and after earnings announcements.
With my proprietary tools, I can show you the historical behavior of stocks around earnings announcements, including how IV impacts a stock’s price in both the run up to the announcement and the aftermath.
This is how I pinpoint stocks with the chance to make the biggest price moves (in either direction), and how I know when to close down my straddles.
The following screenshot shows the price % move after
the earnings on a list of stocks:
Click to View
This next list shows the best price % move prior
Click to View
Finally, you can even analyze what IV does prior to and after the earnings announcement. The image below shows you what happens to IV after the earnings announcement:
Click to View
Knowing how the underlying stock has behaved during past earnings announcements can give you a better chance at profitably closing out your straddle.
Here’s Your Trading Lesson Summary: Using the Straddle to Trade Earnings
The best way to trade options during earnings season is to use my favorite non-directional trading strategy: the straddle. The straddle allows you to profit whether the stock moves up or down on the announcement, so long as it moves enough to cover the cost of the trade. Some considerations:
- Once you don’t have to guess the direction of the price move of the underlying, the question becomes: do you close down your straddle before or after the earnings announcement?
- There are risks to closing out early (missing profits from the announcement itself) or holding your trade too long (IV crush or time decay bringing down the price of your options).
- The best thing to do is know your history – research how the underlying stock has behaved during past earnings announcements, and trade accordingly.