For many options traders, earnings season equates to trading dilemmas; should a straddle or strangle be entered before an earnings announcement to profit from an expected big movement afterwards or should iron condors or iron butterflies or even naked short options be entered to profit from the inevitable implied volatility crush after the news event?
If the stock doesn’t move much at all after the earnings report, the straddle and strangle strategies suffer from implied volatility crush while if the stock moves much further than expected the iron condors/butterflies and naked short options run into trouble. For the iron butterflies/condors, maximum risk is incurred if the stock moves beyond the long option strike prices. If naked short options were entered, the risk associated with the short calls is theoretically unlimited if the stock were to keep rising while the losses in the naked puts would continue to accumulate if the stock were to continue dropping.
In short, trading at earnings appears nothing short of gambling. None of us know (or at least should know) with certainty which direction a stock will move subsequent to an earnings report. As good as our estimates may be, a chance always exists that a stock will move opposite to our expectations. For example, we may have created a fundamental thesis that postulates a stock will drop at earnings based on what we project will be disappointing earnings or revenues figures. However, if management reports in a conference call that forward-looking guidance is considerably more positive than analysts’ estimates, disappointing results may quickly be disregarded by investors in favor of the rosy guidance. Even if we do manage to correctly assess the direction a stock will likely move, the magnitude of the move is certainly in doubt.
If we take a look at a history of how Amazon’s stock moved following earnings courtesy of www.optionslam.com we can see that sometimes the stock moved substantially post-earnings, but the final movement by the end of the month was considerably lower. Sometimes, it moved substantially and failed to retrace, and sometimes the stock failed to move much at all! So, while entering trades at earnings is fun and provides an adrenalin rush, it seems initially that betting on any given move is akin to gambling cloaked in sophistication.
But perhaps, we are too quick to dismiss! If we analyze a little further, we can spot a pattern of behavior in the options of some stocks as they approach earnings. For example, in the chart below courtesy of www.ivolatility.com, we can see that implied volatility in Amazon’s options tends to increase substantially a few weeks before earnings and tends to drop off a cliff immediately after earnings.
Amazon’s options are not the only ones to display this kind of sawtooth pattern in implied volatility. The chart below displays the implied volatility (yellow) versus the stock volatility (blue) of Netflix’s options. You can see similar patterns for both Netflix and Amazon. Indeed, the implied volatility patterns of many other stocks are similar.
So, how do we take advantage of these patterns? Simple! We can purchase long options in the form of a straddle or strangle 2-3 weeks before an earnings announcement in expectation that implied volatility will increase. Sometimes, the implied volatility increase can be so substantial prior to earnings that the straddle or strangle can turn profitable, even without the stock moving much! Then, right before earnings (for example, 1-2 days before earnings is due to be released), short options may be entered against the long option positions. Essentially, this means we are buying "cheap" (as in low implied volatility) long options prior to an implied volatility spike and selling "expensive" (as in high implied volatility) short options prior to an implied volatility crush.
As always, anytime you’re considering a new strategy, please invest the time paper trading or virtual trading it to prove it to yourself. Investing a little time and effort practising usually saves a lot of time and money later!
