How to Play Earnings
Earnings season comes with a mixed bag of lucrative opportunities along with increased risk from the unknown circumstances surrounding earnings announcements. Are you wondering how to play earnings with limited risk?
Options give traders an excellent tool to do just that. In this article, I’ll show how to prepare to trade for earnings season, and how to use options to control risk while capturing potential moves during to earnings season.
Stock movement during earnings season can be completely nonsensical. Like most traders, you’ve probably noticed how sometimes earnings can be horrendous yet the stock goes up?
Or earnings are off the charts fantastic and the stock goes down? This is what I call the Earnings Confusion that can drive stock traders crazy!
Risk from Trading Earnings
Earnings announcements are full of uncertainty. This uncertainty makes the option premium extra juicy, which is a huge advantage if you’re an option seller. The downside to all that uncertainty is the extra risk for traders.
When a company has an earning’s conference scheduled, many times there is speculation not only into the accuracy of the projected earnings per share (EPS) but speculation related to other factors as well. These unknown factors can range anywhere from a CEO’s sexual misconduct (evermore popular these days!) to a takeover or merger announcement.
This uncertainty typically causes volatility in the shares themselves. The diamond in the rough, however, is actually the temporary parabolic increase in the exchange-listed options on the underlying stock.
Pre Earnings Option Strategy
Here’s what typically happens during earnings season…..
Traders tend to stay on the sidelines pre-earnings once the earnings conference call is announced. There’s just too much uncertainty for most traders to feel comfortable taking a firm stand on an unknown outcome.
Then, suddenly, traders realize they need to take action to reduce their risk before the earnings announcement.
1. Call buyers will swap out shares of their long stock for long call options so they can participate in a rise should the shares move higher while limiting the potential loss should the shares trade lower.
2. Additionally, put buyers force the options higher as they try to protect their positions from any major downside movement.
In many cases, all this concentrated option buying will drastically expand the volatility levels of stocks being traded into their earnings release.
So as an earnings season individual trader, you can strategically take advantage of all this uncertainty and volatility, no matter what those crazy earnings reactions are. The key is to use the right setup before the earnings announcement.
How to Prepare for Earnings Season
One of the most important aspects of trading earnings successfully is to get prepared before the earnings season starts. This sounds simple, but earnings season comes around four times a year, so it catches most traders off guard.
You can have an advantage over other traders simply be being prepared before the earnings season even begins by making a list of earnings season trade candidates. Each time earnings season rolls around, you can reevaluate your initial list thereby saving time.
Step 1 for Earnings Season Preparation
Identify and qualify a particular stock by looking at its past performance heading into its earnings release.
Step 2 for Earnings Season Preparation
Find those stocks that have their earnings release closest to a weekly options expiration or during the week of monthly options expiration.
Step 3 for Earnings Season Preparation
Look at the past performance to see specifically what volatility has done previously to a stock as it moves closer to its earnings, and also after its’ earnings release.
- Prepared traders look for dramatic increases in a stock’s volatility as it approaches its earnings release.
- A stock’s volatility may normally be around 25% to 40%.
- BUT the week of earnings and a couple of days before option expiration, its volatility can easily move to extremes…
How to Find Good Earnings Trades
There are two major factors that make a potentially great earnings season stock.
1. A stock’s past performance during earnings season, as covered above
2. The increase in its implied volatility during earnings season
Implied volatility is an excellent factor to identify good stocks to trade in earnings season.
Note that implied volatility will normally double around earnings announcements. In some cases, implied volatility can be even more extreme!
This extreme implied volatility can be a huge advantage for traders during earnings season IF they know how to capitalize on it while also controlling their risk. This is what makes earnings trading so popular.
Four times a year opportunities present themselves through high implied volatility. While high implied volatility is the norm during bear markets, it is hard to find during tame markets.
The higher the implied volatility, the higher the option premium, making earnings season an excellent time for option sellers.
You can check for implied volatility in your brokerage trading platform, as shown below.
NVDA Earnings: 5/11/18 ~ Option Exp. 5/12
Remember, since certain stocks tend to be repeated candidates for earnings season trades, it is essential to have a watch list of stocks to monitor closely due to the fact that they may not all present an equal trading opportunity for an earnings trade.
Keep sight of the goal which is to take advantage of the temporary rise in volatility while considering past earnings performance.
Like all trading, earnings opportunities are about being aware of and maximizing probabilities.
Three Types of Trades for Earning Season Trades
There are three major earning season trades.
- Trend Trade into a Stock Earnings Release
- Stock Earnings Release (Non- directional Trade)
- Trend Trade Post Stock Earnings Release
Earnings Trade 1: CRM Trending Higher Into Earnings & Implied Volatility Trending Higher
Here is an example of a trend trade into a stock earnings release. Notice how the price is trending smoothly upward ahead of the earnings release. This is common when a good earnings announcement is expected.
Trade 2: CRM Non-directional Trade – Volatility Collapse
Notice in the stock chart below how the price spiked sharply up and down. This typically happens when there is an earnings surprise. For this reason, you want to have a non-directional trading strategy that works regardless of whether the stock goes up or down.
You can get my eBook that shows several non-directional trading strategies here.
Trade 3: After Earnings Trend Trade Higher
Here is an example of a trade after the earnings release. Notice how the price stabilized and started a new trend right after the earnings announcement.
Volatility is Key for Earnings Trades
A stock option needs volatility to drive the premium. Without volatility, you have no price movement, and without price movement, you have little chance to turn a profitable trade.
Again, you can easily check the volatility for any stock by going into your brokerage trading platform and looking at the Implied Volatility to find good stocks for trading earnings. This is a free method that works fine, although it takes a little time to go through each stock.
More seasoned traders like shortcuts, so I created a process for building a high probability earnings season list of stocks that I include in my Earnings Course which can be found here.
The screen I developed finds past earnings performance of high volatility stocks. It also screens out these specific stocks with weekly options.
You can definitely do this research on your own, so I’ll share my criteria below to make it easier for you to create an earnings season watch list.
My screen uses & tracks the following data for all stocks selected, which you’ll want in your own screen:
1. Stock’s Volatility – Explained above.
2. High Liquidity – The stock must trade over 1 million shares per day. Again, it must have liquidity.
3. Pre-Earning Implied Volatility to forecast the stocks Expected Implied Move after its earnings announcement
4. Track Prior Post Earning Moves from 1 day after earnings release to 21 days after earnings release to identify any post-earnings trends
How to Play Earnings Season Using an Option’s Implied Volatility
Okay, you’ve got a list of stocks that typically have high volatility during earnings. Now what?
This gets a little complicated, but it’s worth it so stay with me. The beauty of using options is that the Greek data available (for free on your brokerage platform) with options allows you to actually forecast the range of a stock price during the lifetime of a related option. You can imagine how helpful this is going into the earnings season.
This price range prediction is done using a stock option’s implied volatility to forecast the stock’s probable movement. This price range is called the stock’s “expected implied move” in trading lingo.
The option’s implied volatility is expressed as a percentage of the stock price. Not to nerd out too much on you, but this is known as a one standard deviation move.
Understanding and using this highly probable price range is the foundation of a successful earnings trade.
This is because the implied expected move is what the marketplace theoretically expects the price of a stock to do. Here’s an example of the potential price range with using an Option that will expire in 3 days showing an Expected Implied Move of up or down 4%, which is up or down $20 per share.
You can see from this chart that there is a 68.20% probability that the stock price will be in the range between $480 and $520 over the life of the option. That means there is an almost 70% probability of the stock price being in this range. This information can be used to choose the highest probability trade setup for success during the earnings season.
Although this method is not always 100% accurate (what is?), implied volatility, and using the implied move of the stock is an excellent free tool for forecasting a stock’s price movement.
Which Options to Use for Earnings Trading
Traders can use either monthly options or weekly options to trade earnings season.
Options that expire on a weekly basis, or “Weeklys”, are one of the most lucrative trading opportunities that exist today due to their low cost, and highly levered potential returns. For this reason, weekly options offer an advantage over monthly options as a way to play earnings.
Weekly Options take advantage of two key option pricing components that are at the core of earnings trading strategies:
- Time Value
- Implied Volatility
The combination of these 2 components, when used correctly, can benefit earnings trades.
You can see why traders like to play earnings season. Option sellers thrive on getting a high premium that happens every earnings season for many stocks. Plus, past data can be used to increase the probability of winning trades in subsequent earnings season. Coupled with a strong list of companies that are most suitable for earnings trades, earnings trading can be a rinse and repeat opportunity that happens four times a year.
Add to this the fact that you can use an option’s implied volatility to estimate the price of a stock with a 68.20% degree of probability, and you’ve got some real tools for successful trades.
Original Chart Source: Think or Swim Brokerage Platform