Dear Reader,
The majority of S&P 500 member companies have released earnings from Q2, 2022 – and although most companies reported EPS above estimates, they lag behind both 5 year and 10-year averages.
And looking forward, analysts expect S&P 500 earnings to get worse before improving.
The vice president and senior earnings analyst at FactSet, John Butters, wrote, “In aggregate, companies are reporting earnings 0.6% above estimates,” which marks the lowest surprise percentage reported by the index since 2008.
Additionally, as Butters noted, analysts are projecting earnings growth of 3.4% in Q3 this year before improving to 10.5% by fourth quarter.
Which means if earnings are going to deteriorate further, we can expect a shake up in market volatility, and you know what that means… a spike in options implied volatility.
And as you well know, I love heightened levels of volatility. It’s the stuff option traders long for.
So, let me show you how to use the 3-step trading approach to profit from turbo-charged implied volatility as we wind down earnings season this month.
Implied Volatility (IV) – The Secret Sauce That Boosts Option Premiums
My Vega Burst Traders locked in profits from a Straddle trade on Alibaba Group (NYSE: BABA) recently, so I’ll show you how we used the 3-step approach to profit.
I’ve provided a chart below to highlight the 3-step approach to trading IV.
Before I get into it though, let me first quickly explain what an options Straddle trade is.
It’s fairly simple, instead of buying a single call option, you will also buy the same strike and expiration put option – which, when combined, creates a Straddle trade.
The trade set up is quite simple, but be mindful that you’re buying two options instead of a single one, which essentially can double the invested dollars for the trade.
Now, there is some sanity to the madness of buying both the bullish call and bearish put options simultaneously.
The reason we’re buying both the call and put option is because we don’t want to worry about which direction the stock’s price moves… so long as it moves either up or down.
With the call option, we can profit from a strong upward move; and, with the put option, we can profit with a strong move downward as well.
The trade my subscribers took was a Feb 3, 2023 $120 Call/Put Straddle.
Now let’s look at the chart above, which illustrates what’s happening in the 3-step process. It’s this approach that you can follow to profit with Straddles.
Step 1 – Enter the trade ahead of earnings and before the IV rises. If you look at the red trend line in the chart, you can see implied volatility rising upwards during Step 1. This rising IV tells us that call and put options are becoming inflated, which is really good for option buyers.
Step 2 – Watch for a strong price movement in either direction. In the case of our straddle, the stock was moving quite sideways before its big down move, but that’s exactly what we want to happen for Step 2. Once price moves, and remember it must move for us or we’ll have to exit early, we’re ready to move on to step 3 in the process.
Step 3 – Exit the trade before implied volatility is drained from our options. If you notice the red line in the chart, immediately after the price of the stock fell, the implied volatility started falling hard… it occurred right after the event. This simply means that option premium (value) is being drawn out of the options at top speed.
I love rising IV for a reason… because it inflates option premiums. So, we certainly don’t want to be holding long options as their inflated market values are drained due to crashing implied volatility. It’s a swift way to lose money in option trading.
There is a right way and a wrong way to go about option trading around earnings season, and, although most stocks in the S&P 500 have reported, and earnings are winding down, there are still opportunities available.
My AI-driven software, Brutus, continually looks for opportunities. It will tell us just when those opportunities are approaching, and it’ll give us exact entry and exit dates along with the expected amount of turbo-charged IV we could experience in the trade.
So, be sure to tune in with me on Money Morning LIVE each Monday through Wednesday to find out which opportunities are knocking on your door.
Until next time,
Tom Gentile
America’s #1 Pattern Trader
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