9 Weeks to Better Options Trading: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
Veteran options trader Steve Smith breaks down special situations.
Earnings are always tricky in that there are many moving parts that need to be gauged; what is expected, what the actual results are, what the options are pricing in, and what the reaction will be.
One can usually assume that implied volatility will decline immediately following an earnings report. For this reason, I always suggest using some type of spread when playing earnings, whether vertical, butterfly, or condor, as described in previous articles (see the list below), to offset a decline in IV. Also, it makes sense to keep the size of earnings-driven trades small as these are often speculative singular events in which you won’t have time for a thesis to play out, or for a position to recover if you are wrong.
For example, Digital River (DRIV) is set to report earnings on Thursday. The implied volatility of the May options is running around 55%, higher than the 30-day average of 41%, and also well above the 30-day historical volatility at 35%. Following the report, no matter what the results turn out to be, one can expect implied volatility to revert to the mean, or around the 41% level.
This means that all else being equal, the May $19 calls, currently trading around $0.80, will lose about $0.15, or 18% of their value after the report. That likely decline in implied volatility means the purchaser of calls has a major headwind to overcome. To help mitigate this “post earnings premium crush” (PEPC), one could consider selling the $21 calls for around $0.30 to create a $19/$21 vertical spread. Again, no matter what happens, those $21 calls sold against the $19s will also suffer a PEPC, helping offset the implied volatility value lost in the long calls.
These occur when a company warns of a profit shortfall and or raises guidance before the official earnings release, a sudden change in management, or other unscheduled news events such as lawsuits or accounting issues. I generally stay away from issues of lawsuits and accounting as they fall under the “cockroach theory” -- that is, there are usually more of those bad buggers around than first appear. In most cases, the best move is no move.
Fading the News
However, on warnings and shortfalls, I will usually take a “fade” approach. That is, if a stock gets whacked on an earnings warning, I might sell some put spreads to set up a moderately bullish position. When big news hits, the first move is usually an overreaction, and implied volatility will initially jump dramatically. Subsequently, one can expect both price and implied volatility to stabilize once the news is digested.
One example of this came back in January, when JC Penney (JCP) shares jumped some 25% on the announcement that Ron Johnson -- the brains behind the Apple Store (AAPL), gush gush -- was taking over. He may be a genius, but the stock was clearly pricing in a lot of good things that would take some time to play out. Selling call spreads proved to be a safe and simple way to fade the news.
Wrapping It Up
I thoroughly enjoyed writing up this series, and I hope it proved helpful as an introduction to the versatility of options.
More importantly, I hope it sparked even more questions and interest in learning about options, and I look forward to your feedback so I can build on this series over time.
In the meantime, if you have any questions regarding options or feedback on the series, feel free to drop me a line.
Here is a complete index for the 9 Weeks to Better Options Trading Series:
Week 1: 5 Rookie Mistakes Options Traders Make
Week 2: Option Pricing Basics: Understanding Implied Volatility and Time Decay
Week 3: Trading Strategy: The Power of Calendar Spreads
Week 4: Trading Strategy: Butterfly Spreads
Week 5: Trading Strategy: Iron Condors
Week 6: Trading Strategy: Risk Reversals
Week 7: Trading Strategy: Back Spreads
Week 8: Managing Risk
Week 9: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
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