Quick! What happens four times a year and generates more excitement in the stock market than just about anything besides the latest luncheon speech from Janet Yellen? Yes, it’s CORPORATE EARNINGS RELEASES!
Four times a year, publicly-listed companies are required to step up to the earnings confessional to announce revenue and earnings per share results for the prior quarter and future projections for growth going forward. These are conducted through prepared press releases and conference calls, which brings to a halt literally weeks of “positioning” by the company to control the “message” of their release. They hold their cards very tightly to the vest to maximize the “upside surprise” that can generate a huge short squeeze and create big jumps in the price should the results be good…..or these weeks of “warnings” can create a soft landing for a company that did not generate expected results. Conversely, reporting poor results and surprising the market is an equally effective way to shed multiple points from your share price.
You can think of this as a huge “game within a game” as companies try to position each earnings release as an opportunity to create more shareholder value by working the current system to their advantage. Some are better at this than others; during the Steve Jobs era, Apple (AAPL) would notoriously “sandbag” their numbers, only to generate a huge upward surprise during the earnings release as they continued to completely blow out expectations to the upside. Google (GOOGL) took a famously counter-culture approach when they first started reporting quarterly earnings in 2004, doing their best NOT to “play the game” and being far more transparent than analysts were used to; perhaps they had a glimpse into their future.
So what do these earnings releases mean to options traders?
MOVEMENT and OPPORTUNITY! When you consider that there are roughly 5900 companies listed in the NYSE and NASDAQ exchanges spread out over about 12 weeks of activity, that means that we have an average of almost 500 of these reports a week to consider during the quarter. And what these reports almost universally provide to each of these stocks is “event risk” that creates unpredictable movement in the stock price as the results are released.
Yes, we’ve all seen those 50 point gaps in price that occur after the release, and we’ve checked the options chains before and after the release and dreamed about what it would mean to our accounts had we placed that long call option prior to the release. But over time, is that really profitable? The answer, surprisingly, is a big fat NO. Let’s start by setting the baseline for how most traders execute this trade….
The Conventional Wisdom of Trading Earnings
There are several “conventional” methods of trading earnings that most option traders are taught:
- Buy Straddles - A school of thought taught by more “basic” services is just to buy a Straddle before the release, with the idea that you’ll profit regardless of which direction that the price gaps after the report.
- Buy Volatility Before the Ramp - Another method taught to trade earnings releases is to “buy volatility" well before the event, and then sell out of that position right before the release. These are normally some kind of “long volatility” strategy such as long straddles or strangles.
- Sell Volatility - Implied volatility gets “pumped up” just before the earnings release, so sell that volatility and buy back the options for a profit right after the release. The strategies usually employed for this technique are Iron Condors or Naked Strangles.
So which strategy is best? Which one will lead us to the chosen path of consistent profits?
According to Don Kaufman, co-founder of TheoTrade, “After examining thousands of earnings trades put on by institutional and retail traders over the past fifteen years, the expected return of all of these strategies over time reverts to ZERO!!”
Wait a minute! That can’t be right! All of these educational services are swearing up and down that THEIR earnings trade has a positive expectancy! Let’s look at these different strategy approaches in a little more detail.
Let’s get the easy one out of the way first…..look, if you BUY a Straddle, the “expected move” is already priced into those options already! Buying a Straddle prior to earnings is a great way to provide liquidity to the rest of the options market, and little else. For you to score a positive return, your stock has to move WELL beyond a one-standard deviation move after the earnings release, and even then you’re not done, as you have time decay and volatility compression furiously working against you. This is really a low-expectancy way to trade earnings.
OK, what if we buy that straddle well ahead of time, and take advantage of the rise in implied volatility into the release? Nice idea, but markets are really “smart” and it’s just never that simple. Yes, implied vol DOES rise into an earnings release, but that only offsets the time decay (Theta) that is furiously burning a hole in your options. Again, once in a while you might snag a winning combination, but over time this method reverts back to unity as well.
So how about if we SELL that super-high volatility right before the release, like with an Iron Condor or Naked Strangle? Let’s set the “wings” out at one or two standard deviations and we should win at least 68% of our trades, right? Again, good idea, but when you have that “fat tail” event that crushes a stock price by three standard deviations, you’ll give back ALL of those previous profits, and then some. The root problem with this kind of trade is that you have no RISK CONTROL; you surrender your outcome to the fate of that company’s performance, and you hope for a snoozer of a release.
The point here to tear apart the “usual” trades is to first show you what not to do.
Is there a way to make returns from earnings releases?
Yes, but it’s probably not in the way that you’d expect.
For deeper insights into how to use this concept in practice, sign up for our FREE ebook: The Rebels’s Guide to Trading Options – How to Protect and Profit in Any Market
https://theotrade.com/options-ebook/
The Actual Edge with Earnings Releases
You wanna know the real edge with earnings releases? It’s simpler than anything that we’ve discussed so far…..it’s the TREND. If the overall market is heading higher, If you just bias the trade in a directionally bullish manner, that’s good for a 60% edge. And Kaufman notes that if the overall market is heading lower, then that edge increases to 70%! Some additional homework might pay dividends here, by researching the recent trend of the last four release “reactions” for the stock that you’re looking at, and perhaps focusing on those that lined up favorably with the overall market trend.
So it’s really an application of Occam’s Razor….let’s apply the solution with the fewest assumptions. Let’s trade these earnings candidates with the trend in a directional manner, holding over the event.
I can hear your questions already: ”…but what strategy should we use?!” Yes, it always comes back to the options strategy, doesn’t it?
The Right Strategy for the Job
If we’re going to hold a directional trade over an earnings event, you might be tempted to just trade shares of the stock long or short, depending on your forecast. Yes, that would certainly remove the “Greeks” variables from the equation and would simplify management of the trade, except for one small detail: directional risk. Stock shares carry unlimited directional risk. We need to absolutely LIMIT the amount of capital risk that we take on one of these trades.
The usual leap that one takes next is to long calls and puts; after all, then are fixed-risk instruments, right? But we’re right back to where we started again, because now we have all of those “moving parts” back again with the options greeks, where we might absolutely nail the direction of the reaction after earnings, only to find out that our option has shriveled up to nothing after all of the time decay and “vol crush” has done its’ damage. And we could run through the litany of different debit and credit spreads, finding a flaw with each one of these due to the unique nature of how this “event” risk works against each strategy.
Except for one strategy. It’s really not well-known, it’s not glamorous, but it has precisely the right characteristics for our requirements. It’s called an In-Out Vertical Debit Spread. The long option is one strike in the money, the short option is one strike out of the money, and it creates a very benign, neutral spread that ignores time decay and changes in volatility, while carrying the correct Delta and Gamma characteristics that will allow the trade to make money if our forecast is correct. And as we inferred, the risk is absolutely limited to 1:1; we risk one to make one.
Have a bullish forecast after earnings? Execute a short-term Call In-Out Spread right before the closing bell. Have a bearish forecast after earnings? Execute a short-term Put In-Out Spread.
This strategy is the cornerstone of our directional strategies at TheoTrade, whether we are taking them for longer-term swings where we’re using a “further out in time” series to allow the stock enough time to move…..or using a “front-week” series to buy the least amount of time necessary for trading an earnings release.
Want more information on how we trade and how you can find an edge that others’ are overlooking?
For deeper insights into how to use this concept in practice, sign up for our FREE ebook: The Rebels’s Guide to Trading Options – How to Protect and Profit in Any Market
Recent Comments