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Options for Earnings: Understanding Pricing Mechanics

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The past few weeks has seen a significant increase in market volatility. Expect it to continue as the incoming  wave of quarterly earnings reports begins to wash across the tape just as the debt ceiling fiasco reaches its denouement.

But for now, let’s put aside the politics, and focus on the earnings reports. For some active traders, these jolts of information and the accompanying stock price movements represent terrific short-term money-making opportunities.

Many traders will try to juice the returns by using options -- but there's a right way and a wrong way.

Before getting to some of the concepts and strategies that can be employed in playing earnings, let me provide a caveat: All earnings plays are extremely speculative and should involve a minimal allocation of risk capital. 

What’s Expected

The challenge in trading earnings is that there are many variables that need to be accounted for and correctly forecast.

Not only must you decide if the company will meet estimates (and whether those estimates recently been lowered or raised) and what kind of guidance will be provided, but you also must determine what has already been priced into the stock.

And most importantly for our purposes, you must determine what percentage price move the options are pricing in as measured by their implied volatility (IV). While some services such as Bloomberg provide that data, one can perform the calculations relatively easily.

The down-and-dirty formula would be to simply take the price of the at-the-money straddle -- that is, add the price of the puts and calls, and divide that total by the price of the underlying shares. Remember, the options only estimate the magnitude, not the direction of the price move.

For example, look at Yum Brands' (NYSE:YUM) recent report and reaction. On Tuesday shares closed at $71.60. The $71.50 straddle that expires on Friday closed at $3.20. Thus, we can say the options were pricing in a 4.2% move, which is calculated by dividing $3.20 into $71.60. Note, I am accounting for three days of time premium remaining which would equate to about $0.50.

Many stocks now have weekly options listed during the earnings report period, which means the time premium will be minimal. Either way, the additional step of calculating how much time value is left is relatively easy using a basic options calculator.  

As it turns out, YUM greatly disappointed and the stock tumbled 8% to settle at $66, with the straddle worth $5. So in this case, the move was greater-than-expected and a profit would be realized on the straddle (as well as put options, obviously). But in more cases than not, the options market is fairly accurate in predicting the magnitude of the move. 

What’s Expensive

With the above math in mind, one can try to get a bit of an edge by evaluating whether options are “expensive” or “cheap”. I put those words in quotes because they are relative terms.

Let’s take a look at the two tech heavyweights;  Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG). Both have implied volatility of around 27%.  But when looked at relative to each stock's 30-day realized (or historical) volatility (HV), Google is actually more expensive. 

Google’s HV is 16%, which means that the options IV is running a near-90% premium. Apple's HV, which is 22%, shows that its options are trading at “only” a 45% premium. But again, you must monitor whether Apple’s options IV will creep higher heading into earnings, which come a week later than Google’s.

Prepare for Post-Earnings Premium Crush

The common tendency for a post-earnings premium crush (PEPC) to occur makes understanding the relative “expensiveness” of options and the post-earnings move priced in crucial to improving the probability of achieving a profitable trade.

With Priceline (NASDAQ:PCLN) set to report earnings on October 28, you can see that the implied volatility of its options is following a very predictable pattern:

The question is not whether implied volatility reverts towards historical volatility, but whether the post-report move will justify the increase in option premiums. To help determine, or at least make an educated guess, on this front, we can look at three things:
  1. What has been the average price move following earnings over the past 4-6 quarters.  In Priceline’s case, it has been  9%. This includes an outlier of a 20% move following Q2 in 2012.
  2. What is the overall market volatility? Lately, it has clearly been increasing. This would suggest that individual stocks might also have larger-than-usual moves. During Q1 earnings season, which saw fairly docile markets, many stocks’ options overpriced the resultant earnings moves. In this case selling premium, such as through iron condors, would have been the profitable strategy.
  3. In general, how has the market been responding to earnings reports? For example, has the market been selling mild disappointments or buying mere meets? Right now it’s a bit too soon for a pattern to emerge, but my feeling is disappointments will be punished more severely than beats will be awarded.
Since most options are going to see a decline in implied volatility following the earnings report, it is wise to use a spread rather than the outright purchase of options in making a directional earnings bet. The profit potential may be less on an outsized move, but the probability of profit is much greater -- and of course, downside risk is removed..

Given that most of the popular issues will have weekly options listed for their earnings reports, it would make sense for those looking for the speculative action of earnings plays to stick with the leverage of these short-term contracts.  But remember, this leverage cuts both ways -- if you are wrong, expect to lose 100% of your allocated capital. 

Next week I’ll look at some different names and more specific strategies.

Editor's Note: Steve Smith's OptionSmith portfolio is up a whopping 30% in 2013. Take a FREE trial today, and get his exclusive eBook Beyond Puts and Calls: 9 Step to Profitable Options Trading. Click here to access this offer.
POSITION:  No positions in stocks mentioned.