Simple strategy reaps massive profits on earnings.
It's been a great earnings season for options traders.
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A few weeks ago, Goldman Sachs' options research team looked at the historical returns that would have been yielded by a strategy of buying at-the-money call options on stocks five days before their earnings, and selling them the day after.
Since a call represents the right to buy a stock for a certain price within a given time, this is a bullish strategy that would tend to profit as a stock rises. And since the average stock rises on earnings, those call options tend to pay off, Goldman found.
Generally, the strategy has yielded a profit of 14 percent, and 16 percent when it comes to stocks with liquid options. But as it happens, the first 38 companies with liquid options that have reported earnings have shown call buyers a return of 48 percent, tracking for one of the best years in Goldman's study going back to 1996.
Contributing to the bonanza for options traders have been names like Phillip Morris and Netflix, which would have shown call buyers profits of 793 percent and 538 percent, respectively.
More recently (and outside the timeframe of the Goldman note), the 380-strike call on Amazon expiring in May was trading for about $17 on April 17. On Friday, Amazon shares rose 14 percent on earnings, and as of the close, that same call was worth $66.15. That's a 290 percent profit in a week.
Of course, not every name soars on earnings. But Goldman's point is that because investors tend to be skittish and expectations tend to be overly bearish, stocks rise off of earnings more often than they fall, and the values of call options rise along with them.
However, buying calls outright ahead of earnings may not be the best strategy, some traders warn.
"While the vast majority of positions that we have put on ahead of earnings have been bullish positions, we rarely trade them using outright long calls," commented Andrew Keene, an options trader with Keen on the Market. "The uncertainty surrounding an earnings release creates a huge bid for implied volatility ahead of the release. Once the earnings come out, volatility drops, and this can hurt long options positions."
To reduce the effect of falling options prices on his positions' values, Keene chooses to use "spread" trades, whereby he sells options at the same time he buys them. That reduces his exposure to the overall prices of options ahead of a highly anticipated event.
However, the downside of doing a spread is that one often only captures part of a massive move, rather than getting the unlimited upside.
CORRECTION: This version corrected the percentage of profit in the Amazon options trade to 290 percent.
Trading Option Straddles During Earnings Releases.
Option investors have a unique ability to profit in the market no matter which direction a stock’s price moves. A straddle is a great example of this kind of strategy. A straddle is market neutral which means that it will work equally well in bear or bull markets. These trades have an extremely low probability of maximum loss and can earn big returns if a stock’s price moves a lot.
[VIDEO] Trading Option Straddles During Earnings Releases.
Sometimes stocks move a lot very unexpectedly and other times we can predict this volatility. One of these predictable periods of volatility immediately follows earnings announcements. These happen every quarter and the news can affect a stock’s price dramatically. In today’s video we will use a specific case study for using an option straddle the day before the earnings release for Google.
In order for a straddle to be successful, a stock’s price needs to make a big move up or down. The “straddle” means that you are buying two options, a call and a put, with the same strike prices. Imagine that you are “straddling” both halves of the option chain sheet. A straddle is most frequently entered with the at the money strike prices.
In the example for GOOG the stock is currently priced at $390 per share and the 390 strike price calls and puts cost a combined total of $45 per share or $4,500 total to purchase.
If we imagined holding the straddle through to expiration the stock would have to move at least $45 one direction or the other to reach break-even. Although this article is about short-term straddles, sometimes buying a straddle with a long expiration date can be an effective strategy. You can learn more about long term option straddles here.
This may sound a bit unusual to buy both a call and a put at the same time. New traders often assume that gains from one of the options will be offset by losses in the other. That is true to a point, however, eventually the losses from the losing option will be outpaced by the gains from the winning option.
For example, imagine that the stock breaks out to the upside; the call will begin gaining in value while the put loses value. As long as the call gains more than the put, the straddle will be profitable. That is also true in reverse if the stock begins to lose value. Because both options are long they can only lose what was originally invested while the winning side still retains the possibility of unlimited profits.
Because such a large move is needed to become profitable, it is more likely that the trade will conclude with a small loss. However, because the upside potential for long options is theoretically unlimited a straddle trader is counting on the much larger wins to offset the more frequent losers.
[VIDEO] Trading Option Straddles During Earnings Releases, Part 2.
Trading straddles during an earnings announcement ensures a high likelihood for volatility and inflated option prices. These are the offsetting opportunities and risks of the earnings straddle. If the stock moves a lot the straddle will likely profit, however, if the stock doesn’t move enough the deflation in option prices following the announcement will create a loss.
These offsetting risks and opportunities are not surprising and most short term straddle traders anticipate more losing trades than winning ones. Long term profitability rests on those outlier earnings releases in which the stock moves dramatically and large profits can be accumulated. In the case study from the last article we illustrated a straddle on GOOG that cost $45 per share or $4,500 total. If we assume that the position was held until expiration that means that the stock would have to move at least $45 per share up or down to reach break even.
Calculating the expiration break even is a reasonable way to estimate how far the stock needs to move to compensate for the deflation in the option prices following an earnings announcement. In this case, the stock did not move far enough to make the trade profitable and any potential straddle traders are now faced with two alternatives for exiting the position.
1. Selling to exit the straddle immediately.
Option prices have declined the day after the earnings announcement and currently the 390 calls are worth $13.30 per share and the 390 puts are worth $20 per share. The total value of the straddle is $33.30 per share or $3,330 dollars per straddle. Because this is an actively traded stock there should be no problems selling to exit the straddle and move on to a new opportunity.
2. Leaving one leg of the straddle open for speculation.
Prices for this stock have moved to the downside and if your analysis indicates that there is more opportunity within the new downtrend over the next few weeks you may choose to leave the long put on while the call is exited. There is no obligation for the straddle buyer to have to exit both sides at one time.
You may choose to “leg out” of the spread by selling one side first anticipating that the other side will improve in value before expiration.
Options provide alternatives that can be used as market events unfold. A long straddle is a good example of how a spread can be modified and converted from a market neutral position into an outright long position that can continue to profit if the market continues to trend. It is important to note that this is merely one use for the straddle trading strategy. You can learn more about trading straddles over the long term here. Additionally, more risk tolerant traders may flip the traditional long straddle into a short position that will profit from the deflation in option prices following big announcements. You can learn more about short straddles here.
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Make Money Trading Earnings Announcements.
If you watch the financial news media, you've seen how earnings releases work. It's like the big game on Sunday; it comes with hours, and sometimes days, of endless experts providing their predictions of what the numbers will look like, and other experts providing their strategies of how to invest or trade based on the news. Some would say that it is media overhype at its finest and if you watch the endless flurry of graphics and "earnings central" music, it's hard to argue.
According to CNBC, the percentage of S&P 500 companies that beat their earnings forecast in the first quarter of 2012 was over 70% and according to the Bespoke Investment Group, the average one day change to these stocks was 0.47%. Taking a risk to gain only one half of one percent may not seem worth the time, especially after short term capital gains taxes are subtracted, but investors know that the average stock isn't the type of stock they're after. Instead, they're looking for a stock like Apple that rose $50 the day after they reported blowout earnings. This represented nearly a 9% gain from the day before.
The reality is much different. First, for every one of those big gains, there are stocks that suffer big losses. Riverbed Technology saw a loss of 28.75% of its market value and Allscripts-Misys lost more than 35% since January, but even those catastrophic losses aren't why many investors choose to stay away from earnings announcements. Just because a company releases a positive earnings announcement doesn't mean that its stock will rise. Every trader can tell stories of big losses on the back of what seemed to be an impressive earnings release.
For those who wish to trade earnings announcements, the best strategy is to not try to make it an all or nothing endeavor. Don't look for the big score, but instead look to get a piece of the gains, so that if the trade doesn't go your way, you're also only incurring a piece of the loss.
Proven Ways To Profit From A Stock’s Earnings Release Using These 3 Option Strategies.
Earnings are coming, and you want to trade - I get it .
But typically stocks will jump higher or lower after earnings right?
Maybe the company announced great profits or disclosed more layoffs; either of which could send the stock into a big gaping move.
So how do you trading options around earnings (and profitably at that)?
Today we’ll dig deeper into earnings trades and the options strategies you could use.
The Earnings “Volatility Drop.”
The first big concept you need to understand about earnings is that, in general, a stock's implied volatility will rise as it heads into earnings.
Not because the stock is necessarily more or less volatile but because there is a lot of uncertainties (or risk) around what will happen during the earnings announcement.
This one-time event swells option premiums on BOTH sides of the market. As an options trader, this creates an opportunity to sell relatively expensive options and profit from their decline in value.
Once the earnings are announced, we usually see a “volatility drop” or “volatility crush” ( highlighted on the charts with the green line at the bottom ) and option premiums decline across the board.
Again this is because we are now past the uncertain earnings event and have a relative understanding of the company’s future. Good, bad or indifferent the market is more aware of things moving forward and doesn’t have to price in the added risk.
Start The FREE Course on “Earnings Trades” Today: When companies announce earnings each quarter we get a one-time volatility crush. And while most traders try to profit from a big move in either direction, you'll learn why selling options short-term is the best way to go. Click here to view all 10 lessons ?
Target Options Selling Strategies.
Now of course we don’t always see a volatility drop but in most cases we’ve researched IV will drop very quickly after the earnings event.
Knowing this fact, we need to focus purely on option strategies in which we are net sellers of options.
Within our membership program, we focus on three primary strategies around earnings:
The first strategy we look to enter is either a short strangle/straddle where we sell an OTM put and an OTM call an equal distance from the current market price. By taking a neutral outlook on the possible move in the stock, we minimize our directional guess of an earnings pop or drop.
The last thing you want to do with an options trade around earnings is a big bet in one direction. Your best trade is to stay non-directional and adjust as needed later on.
If you can’t sell options naked or don’t want to take on the additional margin risk, then you can use our 3rd favorite strategy - the short iron condor.
Selling a short put and call credit spread on each side does reduce your risk that a huge move will create a big loss for your portfolio. However, the cost of buying the additional options to protect your position means less potential profit.
Regardless, as long as you stick to selling options with high implied volatility you should be much better off than buying options around earnings.
Exit, Adjust Or Roll Positions After Earnings?
Alright, so we’ve covered why to trade around earnings and that strategies to use, now let’s briefly talk about managing the position after the stock re-opens post-earnings.
In nearly all cases, you’ll see some gap in the stock price as investors react to the company news.
If the stock stays within your strike prices on your position, you can easily exit the trade and close out the position for a profit. This is the ideal situation of course.
But we all know that the market doesn’t always do what we want right?
So what do you do if the stock moves outside your strikes and goes ITM? We do have some options (no pun intended). . .
Your first adjustment should be to roll out your option to the next contract month and take in more premium. For example, if you had a December expiration option you would roll it out to January end (at the same strike price) and take in an additional credit.
With more time and a higher credit on the overall position, you give yourself more time to profit while also moving your break-even points out more.
Additionally, you can also roll in the other side of the trade that is currently showing a profit. If the stock moves higher, you will roll UP the put side, and visa verse on the call side if the market moves DOWN you would move down the call side.
Both of these adjustments will give you a higher statistical chance of making money even if the stock moves against you at first.
NKE Earnings Case Study.
Just the other month we sold a strangle heading into NKE earnings. Here is the video setting up the trade:
After earnings, the stock gapped lower in a big way and forced an adjustment similar to what we covered above. We then sent out another video to our subscribers going over the adjustment in detail which you can watch below:
In these videos, you can see how we took what would have been a losing position and by making a small adjustment turned it into a small winner!
Share Your Best Earnings Trade!
It's okay to brag a little here. . .
Add your comments below and let me know what the best earnings trade you’ve made looked like. What was the setup? What strategy did you use?
Sometimes the best trade isn’t a trade that you make money on but that you reduced a loss on. If so how did you adjust it to reduce your loss? Did you roll UP in strikes or OUT in expiration months?
Here's A Quick Bonus Video Tutorial.
Ever get just bearish on a stock? I know I did on JCP & QQQ a while back.
And when placing bearish trades it's important to consider the cost and the break-even points.
For example, in this video tutorial we’ll show you why our JCP trade gave us some extra “buffer” room in the stock which allowed us to take later a very big profit.
About The Author.
Kirk Du Plessis.
Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D. C., he’s a Full-time Options Trader and Real Estate Investor.
He’s been interviewed on dozens of investing websites/podcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.
Cool. you really amazing , Kirk.
Good question – right before.
Generally we prefer the strangle since it’s a wider break-even point but often if the stock has either a) really high IV rank above 70+ or b) is lower priced making strangles not worth the premium, then we’ll go with the straddle.
You don’t sell the call and wait to play the earnings event itself.
In the Nike realignment, why do you bother buying the far OTM call (as opposed to letting it expire)?
Only if there is value left in the contracts so we can get them off for some money.
Good question and we do this because we need to make sure we take that risk off – it’s worth it to spend a $1 to get rid of the risk than to see the stock totally reverse.
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