Trading stock around the times of earnings releases is a notoriously difficult operation because it requires accurate predictions of the direction of price movement. Wrong predictions can expose the trader to substantial loss if large unexpected moves occur against his position.
Because of the risk associated with these events, many traders use options to define their risk and protect their trading capital. The purpose of my missive today is to present several approaches to using options to capture profits during the earnings cycle and to help present the logic and call attention to a major potential pitfall of using these vehicles in this specific situation.
It is essential to recognize that as earnings announcements approach, there is a consistent and predictable pattern of increase in the implied volatility of options. This juiced implied volatility reliably collapses toward historical averages following release of earnings and the resulting price move.
A real world example of this phenomenon can be seen in the options chain of Apple
(APPL), which will report earnings tomorrow afternoon. The current options quotes are displayed below:
Notice the implied volatility labeled as MIV in the table above for the 605 strike call. The volatility for the front series, the weekly contract, is 59.6% whereas that same option in the September monthly series carries a volatility of 28.3%.
This is a huge difference and has a major impact on option pricing. If the weekly carried the same implied volatility as the September option, it would be priced at around $7.70 rather than its current price of $16.50!
The value of the implied volatility in the front month options or front week options allows calculation of the predicted move of the underlying but is silent on the direction of the move. A variety of formulas to calculate the magnitude of this move are available, but the simplest is perhaps the average of the price of the front series strangle and straddle.
In the case of Apple, the straddle is priced at $33.80 and the first out-of-the-money strangle is priced at $28.95. So the option pricing is predicting a move of around $31.50. This analysis gives no information whatsoever on the probability of the direction of the move.
There are a large number of potential trades that could be entered to profit from the price reaction to earnings. The only bad trades are ones that will be negatively impacted by the predictable collapse in implied volatility.
An example of a poor trade ahead of earnings would be simply buying long puts or long calls. This trade construction will face a strong price headwind as implied volatility returns toward its normal range after release of the earnings.
Let us look at simple examples of a bullish trade, a bearish trade, and a trade that reflects a different approach. The core logic in constructing these trades is that they must be at the least minimally impacted by decreases in implied volatility (in optionspeak, the vega must be small) and even better, they are positively impacted by decreases in implied volatility (negative vega trades).
The bullish trade is a call debit spread and the P&L is graphed below:
Click to enlarge
This trade has maximum defined risk of the cost to establish the trade and a small negative exposure to decreasing implied volatility, and reaches maximum profitability at expiration when Apple is at $615 or higher.
The bearish trade is a put debit spread and the P&L is shown below:
Click to enlarge
Its functional characteristics are similar to the call debit and it reaches maximum profitability at expiration when Apple is at $595 or lower.
And finally, there is the different approach, which is a trade called an Iron Condor, with a broad range of profitability. The Iron Condor Spread reflects the expectation that Apple will move no more than
1.5 times (1.5x) the predicted move:
Click to enlarge
Within each of these groups, there are multiple potential specific constructions of strike price combinations that can be optimized to reflect a wide range of price hypothesis.
Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.