What makes a stock's options' IV spike before earnings?

[mks212 0]

I've been thinking quite a bit about what makes certain stocks good candidates for an earnings straddle/strangle trade, and what makes others bad.  In that vein, I researched the 768 stocks priced between $40-$120 since that is kind of a sweet spot for options prices that are trade-able.*  

 

What I found is that some stocks have absolutely no relationship between IV and earnings announcements.  What was more interesting, is that some stocks used to have a nice IV spike and no longer do.  And also true, some stocks did not spike, but now they do.

 

I think we would all agree that we would be better off if we could better predict which stocks are more likely to experience an earnings related IV spike, and which are not.

 

Some of my initial hunches are to look at stocks that are more volatile (i.e. NFLX, EBAY) and also stocks that have had large earnings surprises in recent quarters.  It does appear that the more volatile stocks tend to have more earnings related IV spikes.  I am not really able to test the second hunch since any list I find of stocks that have had earnings surprises has mainly lower priced stocks, many below $10.  However, my reasoning is along  these lines: "Stock XYZ had a huge earnings surprise in the 4th Quarter, so now, going into earnings seasons in the 1st quarter, we would expect the IV of XYZ's options to spike."

 

I would love to hear (read) input from other members and ideally be able to better set ourselves up for earnings season with higher probability trades.

 

Thanks,

Mike

 

 

*These stocks have options priced to accommodate a portfolio of $10,000 or $20,000 allocating 10% to each trade.  For the stocks less than $40, you have to buy so many contracts that the commissions start to really eat into your profits, and for stocks more than $120, even doing a straddle with 1 contract may be more than 10% of the portfolio.

 

 

[Guest Corto]

I will qualify my response that I have canceled my subscription and will only be around for four more days, so please everyone take my comments with that in mind, good or bad.

 

 

The comment:

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"What I found is that some stocks have absolutely no relationship between IV and earnings announcements.  What was more interesting, is that some stocks used to have a nice IV spike and no longer do.  And also true, some stocks did not spike, but now they do."

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is the reason I am moving on.  I was unable to convince myself that there was a relationship the could be predicted by looking at history.  Every earning cycle is different, every cycle has a chance of pre-release to the general public or only a select few of information that can make the result more, or less, volatile.

 

To be totally up front, Kim, recently has been doing a great job of balancing the IV trades with calendars which recently have been good trades that I wish I were in.  But I originally joined for the non directional trading, and have enough risk outside of that in my regular portfolio that I chose not to continue.

 

Regards,

 

Mike

[Kim 7,943]

Mike and Mike,

 

Like we discussed several times, there is no reliable way to predict which stock will experience enough IV spike in any given cycle and when. If there was, each one of us would be a millionaire. This is a difference between probability and certainty.

 

In general, we are looking for fairly volatile stocks that move at least 4-5% after earnings. There are always exceptions, but typically those are the best candidates.

 

Now, lets be clear: for those "good" candidates, there will always be an IV spike. The big question is: will it be enough to offset the theta? It will always be a race between theta and vega. In 90%+ of the cases, there will be some point in the final week before earnings that buying at that point will be profitable. In other words, the vega will offset the theta going from that point forward. Of course the trick is to catch this point in time. If we buy too early, we might be in a trade for few days where theta is winning, and when IV spike starts, we are already behind. If we buy too late, we can miss the IV spike.

 

This is where backtesing comes in play. It shows us when was the best time to buy historically and at what price. it does not guarantee that history will repeat itself, but it will increase the odds. In addition, if the stock moves and/or overall IV increases, that increases the odds as well.

 

Now, if you look at our last few trades, we had the combination of worst possible conditions:

1. Short time to expiration;

2. The stocks didn't move;

3. Overall IV was on constant decrease.

 

Those conditions caused the longest losing streak since SO inception, but even under those worst conditions, most losers were in the 7-10% range. 

 

Of course earnings surprises will always increase the uncertainty and increase the chances of the IV spike. But then again, the big question is the timing. Many times it starts well in advance, in other cases the big spike comes just 2-3 days before earnings. What I usually do to increase the odds (in addition to backtesting) is watching the straddle price for few days. if I see that the price is slowly decreasing, I wait till it stabilizes for 1-2 days and buy. Sometimes I will miss the spike, but at least I get some margin of safety.

 

On a separate note, you are correct in general regarding the price range of the suitable stocks, but we also need to take IV into consideration. What really matters is the price of the straddle and not the price of the stock (although they are related). For example, while BMC and GMCR are both ~40 stocks, but BMC straddle is currently trading at 2.50 while GMCR is around $8. In general, when it comes to commissions, I would prefer the straddle price to be over $2, in which case commissions will take 1.5% or less from the straddle price (with IB). Of course $6 straddle are even better, commissions will be only 0.5%.