Earnings Volatility Is Heating Up – How You Can Profit

The CPI is out and consumer prices increased 6.5% from a year earlier, which is significantly off June’s 40-year high of 9.1%.

While inflation is off its high from last year, prices still increased, but there may be a silver lining… wait for it, the report was considered good because it marks the slowest annual gain since October 2021 and was in line with economists’ estimates.

We’re certainly not out of the woods yet by any means. Inflation is increasing still, just more mildly. We’re likely on the right path perhaps, but we can count on additional market volatility in the months ahead.

Investors were watching the CPI report with the intensity of a boy eyeing a new bicycle, and the market reaction was somewhat anticlimactic. So now it’s time for investors to turn their attention to something else that will be sure to impact the general market… earnings.

Over the next several weeks, companies are poised to expose the dents in their profits as interest rates have been shooting up, and the changes they may have to make in the coming months to continue combatting the high cost of borrowing.

Which means I expect market volatility will continue into this year as it had last and to profit from it.

So, with earnings in the spotlight, let me show you how we can profit from the extra volatility associated with earnings season.

Earnings Season Is an Exceptional Time of The Year

Earnings season occurs four times a year, and it’s one of the most highly anticipated events for market participants.

I’m referring to the time when financial reports from publicly traded companies are released to the public.

The first earnings season of the year is on right now. This month begins the time when companies will report numbers for the prior quarter, and give guidance for their future.

In strenuous economic times such as these, these reports are very likely to increase market volatility.

The Fed has been relentless in raising interest rates, and it has all but promised there will be more hikes this year.

Well, inevitably, harsh borrowing conditions will catch up and adversely affect companies, and manufacturing will suffer, and the domino effect eventually leads back to lower expected future profits.

The depth and breadth of anemic corporate profits is still to be determined for this year, but it’s what market participants will be diligently scrutinizing this year.

And, the uncertainty and anxiety anticipated from corporate earnings will set up trading opportunities for us.

Here’s the thing… many people see the profit potential that earnings season brings to the table, but they don’t know how to trade earnings properly. There’s a right way and a wrong way to go about earnings trading when it comes to options.

Let’s talk about the right way to profit from earnings.

Implied Volatility Is Key to Successful Earnings Trading

You may have learned already that time is an enemy when buying options. Essentially, the price of an option can deteriorates from the purchase date to its expiration date.

This simply means that when buying option calls and puts, we as traders want the security to move in our desired direction as soon as possible – and by doing so, we can maximize profit potential.

Well, there’s a component to an option’s price that’s not understood so much – that component is implied volatility (IV).

I mentioned that time can be an enemy for option buyers, and that’s because part of an option’s price tag (market value) is based on the number of days remaining until it expires.

So, for example, a call option with 30 days until expiration may have a market value of, say, $9.00 per share. Whereas the same call option that has only 15 days to expiration may be worth $5 per share.

The difference is simply time – the less time remaining, the less market value an option will have.

So, let me tell you a little secret that too many option traders are not aware of – the IV impact.

This critical concept can mean the difference between a winning and losing trade.

Implied volatility influences the time value component of an option’s market value. So, when an option has a market value of $9, per the example above, and implied volatility inflates, the option’s value may increase, say rise to $10 per share, or if implied volatility deflates, the option’s price can decrease, say drop to $8 per share.

So, let me show you how we capitalize off the IV influence.

In the image below for Apple, Inc. (AAPL), the red trend trendline illustrates IV rising and declining – which is to say pumping value into option prices or vacuuming value out of option prices.

The yellow arrows point to Apple’s last two earnings reports.

Now, notice the red trend line rises in the days and weeks prior to the earnings releases – this simply illustrates option values becoming inflated prior to earnings reporting.

Then, immediately after earnings report, in both cases above, the red line illustrates collapsing IV, which means option premiums are deflating in an exponential fashion.

You can learn by my chart above that it can take days and even weeks for IV to climb and pump-up option premiums, but it can be a matter of minutes or hours for IV to fall off a cliff – which significantly drains option values.

You or someone you may know may have experienced losing money on an option trade even if though the stock’s price moved in the desired direction. The main reason for this is collapsing IV.

The solution is knowing which side of IV we should be trading on.

Having a clear understanding of how IV affects option premiums is the very reason my Vega Burst trade alerts are sent out to subscribers before earnings, not after.

Having a knowledge of the influence of IV on options puts you ahead of other option traders.

And now that you understand a bit more about the impact of IV on option trades, you’re one step closer to trading earnings the right way.

Until next time,

Tom Gentile
America’s #1 Pattern Trader

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