Trading equities around an earnings report can be exciting, to say the least. To be successful you would need to project what the earnings results might be for a company and then you may need to determine how the markets might react to that earnings report. That is one unknown on top of another, and you basically need to be right about both issues to be meaningfully successful. With options, however, you can play a different game. Instead of determining the direction and magnitude of a move, you can make a trade based on how much the stock might move regardless of direction. How can we do this?
First, let’s take a look at what the options market is predicting the move will be. But how can that be known? Actually, it’s very easy. All you have to do is look at the price of the straddle in the closest expiring weekly option series. A straddle’s price is the price of the at-the-money put and call added together. So if XYZ is reporting its earnings today and trading at 100 and has a weekly option chain expiring in three days, you’d want to look at the price of the 100 straddle. If the price is $6, that means the market is expecting a $6 move in either direction, or 6% of the stock price. Now, armed with that information how might we take advantage of it?
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The next thing you might consider doing is looking at the history of earnings over the past year or two to observe the average move related to earnings. This could give you some perspective. If, for example, the stock usually moves less than 6%, that might be a clue that the straddle is overpriced. If the current straddle is priced much higher than the normal earnings move, you need to do further research to make sure there is nothing unusual about this particular earnings report, like a new product announcement, for example. Regardless, if you feel that the straddle is overpriced, how can you play this? You could sell an iron condor with short strikes one strike beyond the predicted move implied by the price of the short straddle. In our example, since the straddle is worth $6 then you could place your put short strikes at the next strike beyond 94 (100-6). Thus, the short put strike would be placed at 90.
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With the same reasoning, you would put your call short strike at 110. This gives you a nice cushion over the 6% that is priced into the straddle, which you believe to be overpriced anyway. If you are right, and the price moves less than predicted, your iron condor should be profitable very quickly as the two credit spreads of the iron condor lose value as a result of the “volatility crush” of options after earnings. You see the excessive price of near-term options as earnings approaches evaporate quickly afterearnings are announced.
If, however, your research shows that the straddle price is cheap compared to prior earnings moves and thus you think the stock will move more than is priced into the straddle, you can buy the straddle itself. The risk of course is if XYZ doesn’t move much and thus the value of the straddle will be lost due to the post-earnings volatility crush.
So as you can see, the iron condor benefits from a volatility crush while the long straddle loses value from the volatility crush, but, in the event of an outsized move, the long straddlewill benefit from the size of the move itself.
In conclusion, weekly options, due to their short duration, furnish you with an intriguing way to trade earnings—provided you do your homework.
Michael Schwartz and Seth Freudberg (Director, SMB Options Training Program)
The SMB Options Training Program is a six-month program designed for novice and intermediate level options traders who are seeking an intensive training process to learn how to trade options spreads for monthly income. For more information on this program contact Seth Freudberg: [email protected].
Risk Disclosure No relevant positions
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