Option Strategies for Earnings Announcements

It examines a strategy of "buying volatility" in the days or weeks prior to the earning announcements by longing straddles/strangles and closing the positions a day before the announcements when implied volatility is at its highest level.

The baseline case is as follows: you enter long straddle position five days before the announcement, using the nearest month options, and close the position one day before the announcement. Using this strategy, they found out that the average return was -0.45%.

So what does it mean for us? You would think that including slippage and commissions, the results will be even worse, probably in the 3-4% loss range. So how do we manage to "beat the statistics" and produce average gain of 4-5%? (As a side note, 20 trades per month at 4% average return and 10% allocation will produce monthly returns of 8% before commissions).

Several factors contributed to the difference between our results and the results in the book.

1. They examine the full universe of all equity options traded over 14 years. While this means "no cherry-picking of good results and brushing aside of bad results", we would not even consider stocks with consistently bad results. We have a selected list of just few dozen stocks which tend to produce the best results over time. This alone should make a huge difference.
2. They limit the holding period to 5 days, entering five days before the announcement and exiting one day before the announcement. We don't have that limitation. We enter our trades between 2 and 14 days before the announcement, based on backtesting results, price, implied volatility, time to expiration etc. For example, for options expiring in less than a week, we usually limit the holding period to no more than 2-3 days.
3. The testing includes 14 years of data from 1996 to 2009. This was before weekly options have been introduced. Now we have a choice of trading weekly options or monthly options, and we adjust our strategies based on market conditions and individual stocks. For some stocks, weekly options tend to work better. For others, monthly options would be a better choice.
4. The testing included closing the trades at the last day only. We don't have that limitation. We can close earlier if our profit target has been hit.
5. The testing is based on End Of Day prices. We can use the daily fluctuations to enter and exit at better prices.
6. We can manage our positions. For example, if we opened a 30 straddle when the stock was trading at $30 and the stock moved to $31, we might roll the straddle to the 31 strike. If the stock moves back to $30, we will roll back to the 30 straddle. This is what we did with one of our recent trades. Using the methodology in the book, the straddle would produce 10% loss, but with proper management, our final return was 12% gain.
7. We use a combination of straddles and strangles. If the stock is trading at $102, they would open a 100 straddle - we would prefer a 100/105 strangle in such situation. This can make a huge difference as well. If the stock is not close enough to the strike, we won't open the trade.

The bottom line is even with such strict rules and limitations, the average return is almost breakeven. This is a definite confirmation that with proper selection of stocks, holding periods, adjustments and trade management, the strategy has positive long term expectancy with very limited risk.