A PRIMER IN TRADING OPTIONS DURING EARNINGS
Let me start this post by declaring that majority of this content has been taken from a Daniel Darrow article.
Its a great article , and it gives a good informative start to my thoughts
Lets Start off with Volatility
Either you're banking on it being high, or banking on it not appearing. Either way, earnings season is characterized by increased volatility, so naturally it is haven for options traders. However, earnings season brings on equal measures of opportunity and risk, so if you are going to be involved, at no time is it more crucial to be educated.
Hence this board !!
Implied Volatility
Within the price of every option includes "implied volatility" - the consensus percentage that traders believe the stock is going to move. After reporting quarterly earnings, stocks often have large price fluctuations, so implied volatility during earnings season is generally higher. When using a straight call or put-buying approach during earnings season, they key is determining which stocks I think will move more than Wall St expects them to.
After Earning Price Moves
To many, the nature of post-earnings price movement can seem somewhat random. Traders and investors are sometimes left scratching their heads when a stock can beats earnings "estimates" but subsequently trades lower.
Although the market can be very unpredictable at times, I do believe there are ways to potentially identify which stocks could exceed their implied volatility. My methods are FAR from an exact science, but the key for me is consistent sizing and betting on the fact that I can be right more often than not. In fact, I don't even need to be right more often than not, I just need to identify a few potential big winners that can cover losses in the stocks that don't pan out.;
1. Market Cycle
One of the most important things to consider when trading options on earnings is the type of market cycle that we are currently in. In 2013, for example, we have seen a raging bull market. The downside movement during earnings seasons has generally been muted, while we have seen dozens of examples of massive gaps up.
In a bull market, people tend to be forgiving to an earnings miss and more rewarding for a beat. During market turmoil, the opposite is true. I believe IMHO , that any options play into earnings should generally follow the trend of the broader market, as well as the sector and stock. That isn't to say that I won't take any puts into earnings reports during a bull market, but I tend to take a top-down type of approach.
2. Stock History in Previous Earnings Moves
A second factor to consider when determining a potential play is the stock's history of earnings moves. While past performance is not always an indication of future results (and large moves are often priced into the options for volatile stocks), I believe the size of the moves in reaction to the most recent 2-3 earnings reports are a useful gauge as to what the next move could be.
I give the most weight to the move from the most recent earnings season. For instance, if a stock has had initial moves of 15% three quarters ago, 10% two quarters ago and 5% the past quarter, then I would say that earnings volatility has been decreasing and I should not expect a large move. In an alternate scenario, if there were moves of 5%, 5%, and 10%, then I could be expecting a large move.
3. Stock Price leading into the Earnings
A third factor to consider is how the stock has moved leading into the report. Aggressive buying or selling in the previous weeks/days prior to a report can eat into the potential post-earnings move. Good or bad news could already be priced into a stock and could potentially eliminate a sharp move. When I believe opinion has reached near-consensus levels, sometimes I take the other side.
4. Short Interest
A fourth factor to consider is the level of short interest, which has been particularly relevant lately. Taken alone, short interest should not be used to determine, which direction to bet on - in fact I think it's a trap many traders fall into. Short interest simply be considered a factor that could exaggerate a move in either direction, particularly the upside.
5. Conclusion
In analyzing a potential options trade, I analyze all of these factors together to identify the stocks I want to play. For instance, a stock trading about 5% from all-time highs with high short interest, that has a history of 7-10% moves following an earnings report could be a candidate for a large move to the upside. In a different scenario, a stock that is approaching a large gap could a be candidate for a gap-fill play even if the stock only has a history of 3-5% moves and the gap might be larger than 5%. In yet a different scenario, a stock that has been in a tight consolidation might be set up for a sharp move in either direction and might be a candidate for a straddle or strangle.
This post was meant to be an overview of a few of the factors I consider, and I will do another post , on the type of options I generally buy.
I feel that trading options around earnings is more of an art than a science, but if you can develop a discerning eye, you could potentially create great trade ideas with well-defined and favorable risk-reward parameters.
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