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Trading Earnings: The Myths and The Reality


Nothing impacts stocks prices more than company earnings reports. There are many way to trade those earnings announcements. You can take a directional bet if you believe the stock will move (higher or lower). Or you can play it with some of the non directional strategies.

Introduction

The first question you need to answer is: will you hold your position through earnings, or will you close it before the announcement. 

 

In some of my previous articles, I described few ways to trade earnings if you don't want to hold the trade through the announcement. Our favorite ways to do it are with Straddles and Calendar Spreads. Personally I don't like to hold those trades through earnings. But if you decide to do so, please make sure you do it the proper way and understand the risks.

So if you decided to hold, the next questions would be: directional or non directional? Buy premium or sell premium?

Here is a simple way to look at potential trades. The options market will always tell you how much stock movement the options market is pricing in for earnings, or any event. 
 

For example, let’s take a look at what the options market was expecting from Apple (AAPL), which reported earnings last month.
 

With AAPL stock trading at 190 we need to look at the price of the straddle closest to 190. And these options need to be the calls and puts that expire the week of earnings.


In this case, with earnings on July 31, we look for the options that expire on Friday, August 3. The calls were worth approximately $4.85, and the puts were worth $4.27 just before earnings were announced. When we combine these two values it tells us that the options market is pricing in an expected move of $9.12, or 4.8%, after earnings. This is what we call the "implied move".

Now you need to do some homework and decide if you believe the options are overpriced (and the stock will move less than the implied move) or underpriced (and the stock will move more than the implied move).

Buying Premium

If you believe that the options are underpriced, you should buy premium, using a long straddle or a long strangle.

If you buy a straddle, then the P/L is pretty much straightforward:

  1. If the stock moves more than the implied move after earnings, your trade will be a winner.
  2. If the stock moves less than the implied move after earnings, your trade will be a loser.

Taking AAPL earnings as an example:
 

The straddle implied $9.12 or 4.8% move. In reality the stock moved almost $12, or ~6.0%. Which means that the straddle return was over 25%.

Strangle is a more aggressive strategy. It would usually require the stock to move more to produce a gain. But if the stock cooperates, the gains will be higher as well. In case of AAPL, doing 185/195 strange would produce over 40% gain (all prices are at the market close before and after earnings).

Obviously if the stock did not cooperate, the strangle would lose more as well. Which makes it a higher risk higher reward trade.
 

Selling Premium

If you believe that the options are overderpriced, you should sell premium. You can sell premium in one of the following ways:

  1. Sell a (naked) straddle. This strategy is the opposite of buying a long straddle, and the results will be obviously opposite as well. If the stock moves more than expected, the trade will be a loser. If it moves less than expected, it will be a winner.
     
  2. Sell a (naked) strangle. This strategy is an opposite of buying a long strangle, and similarly, a more aggressive trade. Take the last FB earnings for example. Selling 1 SD strangle would produce a $208 credit. When the stock was down almost 20% after earnings, the trade was down a whopping $2,407, which would erase 12 months of gains (even if ALL previous trades were winners). This is why I would recommend never holding naked options positions through earnings. The risk is just too high.
     
  3. Buy an iron condor. This strategy would involve selling a strangle and limiting the risk by buying further OTM strangle. In case of a big move, your loss is at least limited. Selling options around 1 SD would produce modest gains most of the time, but average loss will typically be few times higher than average gain.
     
  4. Buy a butterfly spread. This strategy would involve selling a straddle and limiting the risk by buying a strangle. In case of a big move, your loss is at least limited, like with iron condor. This strategy has much more favorable risk/reward than iron condor, but number of losing trades will be much higher as well.
     
  5. Buy a calendar spread. This strategy would involve selling ATM put or call expiring on the week of earnings and buying ATM put or call with further expiration. The rationale is that near term short options will experience much bigger IV collapse than the long options, making the trade a winner. To me, this would probably be the best way to hold through earnings in terms of risk/reward and limiting the losses.

As a rule of thumb:

  • If the stock moves as expected after earnings, all strategies will be around breakeven.
  • If the stock moves more than expected after earnings, all premium buying strategies will be winners, and all premium selling strategies will be losers.

So which one is better?

To me, any strategy that involves holding through earnings is just slightly better than 50/50 gamble (assuming you did your homework and believe that you have an edge). Earnings are completely unpredictable. Selling options around earnings have an edge on average for most stocks, but they have a much higher risk than buying options, especially if the options are uncovered. Those "one in a lifetime events" like Facebook 20% drop happen more often than you believe.

Many options "gurus" recommend selling premium before earnings to take advantage of Implied Volatility collapse that happens after earnings. What they "forget" to mention is the fact that if the stock makes a huge move, IV collapse will not be very helpful. The trade will be a big loser regardless.

Directional or non directional?

So far we discussed non directional earnings trades, where you select ATM options. But those trades can be structured with directional bias as well. For example:
 

If you were bullish before AAPL earnings and believed the stock will go higher, instead of buying the 190 straddle, you could buy the 185 straddle. This trade would be bullish, and earn more if the stock moved higher, but it would also lose more than ATM straddle if you were wrong and the stock moved down. As an alternative, you could buy an OTM calendar (for example, at $200 strike). If you were right, you would benefit twice: from the stock direction and IV collapse. But you would need to "guess" the price where you believe the stock will be trading after earnings with high level of accuracy. If you guess the direction right, but the stock makes huge move beyond the calendar strike, you can still lose money even if you were right about the direction.

For example, the 190 (ATM) calendar would lose around 40-50% (which was expected since the stock moved more than the implied move). But the 200 (OTM) calendar would gain around 120% since the stock moved pretty close to the 200 strike, so you gained from the IV collapse AND the stock movement.

Conclusion

Earnings trades are high risk high reward trades if held through earnings. Anything can happen after earnings, so you should always assume 100% loss and use a proper position sizing. Traders who advocate those strategies argue that they can always control risk with position sizing, which is true.

But the question is: if I can trade safer strategies and allocate 10% per trade, why trade those high risk strategies and allocate only 2% per trade? After all, what matter if the total portfolio return. If a trade which is closed before earnings earns 20% (with 10% allocation), it contributes 2% growth to the portfolio. To get the same portfolio return on a trade with 2% allocation, it has to earn 100%.

Is it worth the risk and the stress? That's for you to decide.

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