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Trading Earnings with Options:  Part 1

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The Reality of Trading Earnings with Options: Part I

By, Dale Brethauer

Hi This is Dale, in this two part free course I’m going to guide you through the reality of trading earnings with options.  Is there an edge to be had? If so what option strategy should be implemented, my research and back-testing shine a light on these heavily anticipated events.  Let’s get started.

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Earnings Season | Overview

Every quarter, we go through earnings season, a time when public companies announce their performance and give guidance for the coming quarter. What’s most important is not the performance from the last quarter but the guidance for the upcoming quarter. Stock market investors are always looking in the future, not in the past.

The Stock market itself is a leading indicator discounting today’s price as a representation of expectations 3-6 months in the future

Many times you might see a company announce better-than-expected earnings and then the price gets clobbered. That’s because its forward guidance given by the CEO or CFO was not all that great for the coming quarter. You have to be careful on earnings. This is a highly anticipated yet nervous time for investors, because they either get confirmation of a company’s strong growth or news or a slowdown in revenues and profits.

3 Option Strategies

There are three strategies you can use to trade earnings season. You can go in with a short strangle, a short iron condor or a long straddle.  In this first part, I’m going to talk about the short strangle and is the implied volatility crush.  The IV crush happens right after earnings and the short strangle trade may potentially take advantage of that crush.

Strategy 1 | Short Strangle

video reference: Implied Volatility Crush

This is a daily chart – one-year chart of Google. What I want to show you in the lower portion of this chart is the implied volatility. Basically, what happens is it comes up to earnings and the market makers know there’s a lot of anticipation around earning, so they will increase the premiums of the options. As soon as earnings and forward guidance is announced, that volatility drops like a rock. Therefore, the price — you might have a certain call  or put where the price is set pretty high. Let’s say it’s a $10 premium. What’ll happen, as soon as earnings are announced, and the implied volatility crush occurs, down goes the price of that $10 call to maybe $1-2.

You say to yourself, “Well, if the option premium is going to drop because of this implied volatility, doesn’t it make sense to sell? Doesn’t it make sense to go way out of the money and sell the options? That would be called a short strangle. A short strangle strategy requires the investor to simultaneously sell both a call and a put option on the same underlying security. The strike price for the call and the put contract must be respectively above and below the current price of the underlying.

The assumption of the investor, the person selling the option, is that for the duration of the contract the price of the underlying will remain below the call and above the put straight price. Here’s  an option chain for Google. The price of Google here at this point was at $890 when I took this screenshot. What you’re going to do is go out of the money, and you’re going to sell the call and put premium. The same thing is true on the call. As long as it stays between $860 and $920, we’re going to take advantage of the implied volatility crush.”

The $860 put had a value — only time value — of $7.65. Then we sold a $920 call at $940, so we took in $17.05 worth of credit. 100 shares per contract. That’s $1,705 per contract.  If the price that was at $890 stays above $860 or below $920 you would collect all the premium. Earnings were announced. Earnings were okay, but the forward guidance was exceptional. Google took a jump, and it jumped above where we sold the call. This call that we sold for $790 now had intrinsic value plus time value. When it came up around here, it was worth $2,195.

In one day, we had lost 29 percent based on the credit, okay? $21.95 minus the $17.05 times 100 was minus $490 on that short strangle. There is no good way to play earnings. Even though it makes sense as far as the implied volatility crush, and even though it makes sense that we want to sell.

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Conclusion

A lot of times, the stock will jump above or below the limits we have set on our short strangle. When that happens, we are in a lot of trouble very quickly. We’re in trouble before the market even opens. Sometimes it works out. It’s hard to determine whether it’s going to stay within the limits or go above or below. It’s really quite a gamble, if you will, and this is just one example of how a short strangle would not have worked. Now, I’m going to continue this discussion the next time. In Part Two, what we’re going to be talking about the last two strategies I backtested – the short iron condor and long straddle.

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