This quarter’s reports will be like no other as the future has become untethered from most projections and the past has no bearing on the future. The numbers from the current quarter, which only includes the first week or two of the shutdown and will be dismissed out of hand; there will be no value to playing the “meet or beat” game.
Further clouding process is that almost all companies that comprise the “SPDR 500 (SPY - Get Rating)” have all pulled forward guidance which is typically the most important item in determining how a stock will react in the following report.
Even under the best of circumstances earnings can be very tricky to trade as there are many moving and unknown parts; will the company miss or beat expectations, what will be the guidance, will traders ‘sell the news’ or buy into the unknown on the belief the recent decline has priced in a near worst-case scenario?
But there is one predictable pricing behavior that savvy options trader uses to produce steady profits. And given all recent volatility, and still, so many unknowns mean options premiums will be at record high levels as market makers need to price options for outsized moves.
So how does one trade earnings in a world without guidance? Here’s a quick guide and it rests on taking an options-centric approach.
Use the Post Earnings Premium Crushed
The one item we can count on is that no matter what a company reports or how the stock reacts the options will undergo a Post Earnings Premium Crush (PEPC) which is my label for how the implied volatility contracts sharply immediately following the report no matter what the stock does.
You can see the repeating pattern of the implied volatility of Netflix’s options spiking and retreating on the quarterly reports.
You’ll often hear traders cite what percentage move options are “pricing in” o the earnings. The quick back of the envelope calculation for gauging the magnitude of the expected move is to add up the at-the-money straddle.
This article does a great job of explaining how to use the straddle to both assess expectations and potentially profit.
Once option traders are armed with this bit of knowledge, they to advance to use spreads to mitigate the impact of PEPC when looking to make a directional bet. Some will graduate to getting this predictable pricing behavior in their favor by selling premium via strangles or the more sensible limited risk iron condors. But these strategies still carry the risk of trying to predict if not the direction, then the magnitude of the move.
Here’s a list of the historically most volatile stocks following earnings reports. This means they are likely to see both the largest increase in implied volatility leading up to earnings and the largest PEPC.
The Pre-Earnings Trade
The true professionals pursue a safer and more reliable path of positioning in anticipation of the increase in implied volatility that precedes earnings and avoids the actual event altogether. Just as PEPC is predictable so is the pumping up of premium leading into the event; it’s just more subtle in that it occurs incrementally over the course of many days.
One strategy for taking advantage of rising IV leading into earnings is calendar spread in which you sell an option that expires prior to the earnings while simultaneously purchasing one that expires after the event. Like any calendar spread it will benefit from the accelerated decay of the nearer dated options sold short. But this has the added tailwind of as earnings approach the option which includes the earnings will see it IV rise causing the value of the spread to increase. To keep the position delta neutral both put and call calendars should be established.
These positions must be established in advance and closed before the actual earnings. The profits might not be as dramatic as catching a huge post-earnings move but they can be substantial. More importantly, they can be consistent and have a high probability.
With weekly options, there should be plenty of situations in the coming weeks to take advantage of the rise in IV leading into earnings. This site provides a good starting point of a list of names and their options specific pricing tendencies.
With most offering weekly options there should be plenty of opportunities for double calendars. As always, do your own research and confirm the reporting dates but this offers a great starting point.
Just remember, a big move doesn’t guarantee a profit, you still have got the direction and what the options expectations were pricing in.
Good luck, keep your distance and happy earnings.
Want more great investing ideas?
The Fake Rally is Over! – Why the bear is still in charge. Along with the right investment strategy to generate profits while stock prices head lower.
How to Make Money in a Bear Market – Learn more about this vital webinar with famed investor Marc Chaikin.
Reitmeister Total Return portfolio – Discover the portfolio strategy that Steve Reitmeister used to produce a +5.13% gain while the S&P 500 fell by -14.97%.
SPY shares were trading at $271.26 per share on Wednesday afternoon, up $6.13 (+2.31%). Year-to-date, SPY has declined -15.23%, versus a % rise in the benchmark S&P 500 index during the same period.
About the Author: Steve Smith
Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...
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