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There are few things that can make a stock price “pop” or “drop” more quickly or harder than an earnings announcement.  A favorable earnings announcement can make a stock gap sharply higher from one trading day to the next and an unfavorable earnings announcement can have just the opposite effect.  As a result manner traders look to “play” earnings announcement by entering into an options position in advance of the announcement.

This is especially true with stocks that develop a history of making dramatic earnings announcements followed by big stock price movements.  Some stocks that might fit in this category are AMZN, AAPL, BIDU, GOOG, NFLX, BIDU, FB, BWLD and CMG, to name a few.

Keeping an Eye on Implied Volaility

One phenomenon that tends to occur to the options on these stocks prior to an earnings announcement is referred to as the “volatility spike”.  In a nutshell, due to abnormally strong demand for options on the stock – especially shorter-term options that expire shortly after the earnings announcement – the time premium in those options soars as the option writers wisely demand larger than normal premiums for assuming the risk of writing the options in the first place.  This spike in time premium is reflected in higher implied volatility levels for the options.

Simply buying options when implied volatility is extremely high is generally a dangerous idea because typically, once the earnings news is out – be it good, bad or otherwise – implied volatility falls sharply and the options see a lot of time premium that was built into their prices vanish.  This phenomenon is typically referred to as a “volatility crush.” On the flip side, writing options prior to an earnings announcement for a volatile stock is also very risky because if the stock gaps the wrong way after the earnings announcement, extremely large losses can ensue.

So what follows is a discussion of “one way” to play earnings using options.  This method essentially involves buy a potentially expensive straddle or strangle (i.e., buying both a call and a put) while offsetting some of the cost by selling a shorter-term very richly priced straddle or strangle.

The Steps

To illustrate the steps in this example strategy we will use the unparelleed analysis tools available at www.OptionsAnalysis.com

Step #1: Identify a stock or group of stocks that have a history of:

1. Experiencing large price movement following earnings announcement
2. Experiencing volatility spikes prior to earnings announcements

See NFLX in Figures 1 and 2.Figure 1 – NFLX often experiences large price movements after earnings (Courtesy: www.OptionsAnalysis.com)

Figure 2 – Implied volatility for NFLX often spikes before earnings and then crashes afterwards

Step #2: Find the two option expiration cycles that:

1. Expire at least 2 trading days after the expected announcement
2. Have at least 50 days left until expiration

In Figure 3 we see that for NFLX this is the Oct14 Week4 and the December options (with 11 and 74 days left until expiration, respectively). Figure 3 – Oct week 4 options have 11 days left, Dec options have 73 left to expire (Courtesy: www.OptionsAnalysis.com)

Step #3: Find the put first put option in the shorter term cycle that has a delta of greater than -45 (i.e., closer to 0, -44, -43, -42, etc.).  Note that put’s strike price.  The goal is to sell a call option roughly equidistant from the stock price as is the put we just found.  HOWEVER, we want to trade the same strike prices in the longer-term options, so you need to make sure the strike prices you find in the shorter-term options are also available in the longer-term options.  Consider Figure 4. 

Figure 4 – Options to trade for NFLX (Courtesy: www.OptionsAnalysis.com)

In Figure 4 note that on the right hand side in the Oct14 Week 4 put options, the first strike to have a delta under -45 is the 452.50 strike price.  However, there is no 452.50 strike price available in the December series.  So we will use the 450 and 465 strike prices.

Also note that at times it may be impossible to match up strike prices without going relatively far out-of-the-money.  Rule of thumb: if the trade doesn’t come together fairly easily, don’t chase it.  Move on to another potential opportunity.

Step #4: Compare the implied volatility levels of the near-term options versus the longer-term options.  If the IV for the shorter-term options is NOT at least 30% higher than the longer term options DO NOTE proceed.  Skip this stock and look for another opportunity.

In Figure 5 under the heading “IV%” we see that the implied volatility for the near-term options are at least 30% above the IV for the longer-term options

IMPORTANT NOTE: The higher the IV of the shorter-term options relative to the longer-term options the better the opportunity (as long as the IV on the longer-term options is not also in the stratosphere).  In essence we are using the sales of the more expensive shorter-term options to help finance the purchase of the longer-term options.

Step #5: Sell two of the near-term puts and two of the near-term calls.

Step #6: At the same time buy three of the longer-term options.

See Figures 5 and 6.  NOTE: It is not uncommon for high IV options and/or longer term options to have wide bid/ask spreads.  It is recommended that you place limit orders and attempt to enter the entire position at one time using a limit order.  See Figure 5. Figure 5 – NFLX trade particulars (Courtesy: www.OptionsAnalysis.com)Figure 6 – NFLX earnings trade risk graph (Courtesy: www.OptionsAnalysis.com)

A couple of important NOTES from Figures 5 and 6.

1. At times this method will require a fairly large commitment of cash in order to enter the position. In Figure 5 we see that the 3x3x2x2 spread will require an “Entry Debit” of $7,9985 to enter. This is not an insignificant amount of money.
2. At the same time, because we will be exiting the trade shortly after earnings – and well before the longer-term options expire – the actual likely risk on the trade will typically be only a fraction of the Entry Debit.
3. In Figure 5 we see a “Max Risk” value of $653.97. This number can increase or decrease depending on the action of implied volatility after the earnings announcement. Nevertheless, the point here is that the actual dollars at risk is almost invariably far less than the Entry Debit – i.e., the cot to enter the trade.

Step #7: If the position happens to generate a profit you deem acceptable prior to the earnings announcement, go ahead and take your profit.

Step#8: If you hold the position through earnings look to take a profit prior to the expiration of the shorter-term options.

Figure 7 shows the status of our NFLX trade at the close on the day of the earnings announcement (which will occur after the close of trading). Figure 7 – NFLX position at close prior to earnings announcement (Courtesy: www.OptionsAnalysis.com)

Note that in Figure 7 the “Rate of Return” shows 50.2%.  Note also that this figure is based on comparing the current Open Profit to the “Max Risk” listed for the trade (which based changes in IV since the trade was entered is now listed as $298.75, down from the original $653.97 value reflected in Figure 5.  Remember I said that this value can increase or decrease).  If we calculate the open profit as $ Profit ($150) divided by Entry Debit ($7,985) then the open profit % is just 1.9%.  As a result we will most likely want to hold the position through the next day.

Figure 8 reflects the risk curves as of the close of trading on the day of the earnings announcement. Figure 8 – Risk curves just prior to earnings announcement (Courtesy: www.OptionsAnalysis.com)

So what happened next?  The earnings announcement was not a happy one for NFLX stock holders.  After closing on 10/15 at $448.59 a share, the stock opened on 10/16 at $332.73 – almost $116 lower – before rebounding to close the day at $361.70.

The option position as of the close on 10/16 in reflected in Figures 9 and 10.Figure 9 – NFLX position day after earnings (Courtesy: www.OptionsAnalysis.com)Figure 10 – NFLX risk curves day after earnings (Courtesy: www.OptionsAnalysis.com)

At this point the option position is showing a profit of $1,143. This represents a gain of 14.3% based on a commitment of $7985 to enter the trade.  The trader would most likely consider exiting the entire position and taking a profit of 14.3% in 9 calendar days.

One other alternative to consider is to leave all or a part of the longer-term position on as a long straddle or strangle.  Not however that the longer you hold this position the greater the loss potential as time decay eats away at both the long call and the long put.

Summary

Certainly not every trade will work out and generate a profit.  A few things to keep in mind:

1. If there is not a wide disparity in the implied volatility of the short-term options versus the long-term options you should avoid the temptation to enter a trade “just because”. The disparity in IV is what gives this trade an “edge” as long as…
2. …the IV for the longer-term options is not excessively high (because they are susceptible to a volatility crush as well) but the IV for the shorter term options has exploded.
3. If you cannot get filled at your limit price you should bypass the trade.
4. There is clearly some “work” involved in executing this strategy.

In a nutshell, we are looking for the best opportunities, which is why we start by focusing on volatile stocks which tend to experience large price movements.

In sum, the above represents a slightly advanced example of just “one way” to play earnings announcement using options.  You are encouraged to do some research of your own before engaging in this type of trading activity, especially if you are new to options trading.

Jay Kaeppel