A company's quarterly earnings announcement is a highly anticipated event for traders - and for good reason. For three months, companies largely trade based on expectations for their next earnings report. While most commentators talk about Wall Street's "consensus" estimates, it is typically a firm's results relative to the collective earnings expectations of individual investors (the "whisper number") that determines how a stock performs when earnings are announced. The reality check resulting from the actual earnings announcement can cause higher trading volatility as investors scramble to revaluate the stock price based on the new information. For option traders, that volatility means one thing: opportunity.
The more dramatic a stock's movement, the more opportunity for profit and (of course) for loss. Opportunities are furthered with options. Options can be used to mitigate risk. They can be used to create leverage. They can also be an interesting alternative to just buying or shorting a stock.
Whether traders think the stock is going up or down, there are many ways to trade options close to earnings reports. The most straightforward way is to buy a call when bullish on an earnings announcement's results.
Buying a Call Before an Earnings Announcement
Imagine the consensus estimate for a company's earnings is 20 cents and the whisper number is 22 cents. A trader believes the actual earnings number will exceed even the whisper number, prompting a sharp rise in the stock price following the announcement. In this scenario, the trader might decide to buy a call. (A call gives its owner the right - but not the obligation - to buy 100 shares of the underlying stock on or before the option's expiration date.)
There are several call choices available to trade on each individual stock. For example, the trader might buy the at-the-money call. An at-the-money call's strike price is very close to the stock price.
With the underlying stock at $50, this bullish trader buys a short-term 50-strike call at $2 per contract (in this example). The trader's goal is to see the call rise as a result of the underlying stock's reaction to a positive earnings announcement, then sell it at a higher price.
There are a couple reasons a trader might choose to buy a call instead of buying the stock. First, when buying an option, the maximum risk is the premium paid for the option - in this case, $2 per contract or $200 of actual cash. Considering that buying 100 shares of the stock at $50 would mean putting $5,000 at risk, the call offers a significant advantage in terms of total risk.
Another advantage is potential profits as a percentage of the investment. If the stock rises $5, after the earnings announcement, a 100-share position in the $50 stock would yield a 10-percent profit. Owning the call at $2, however, might yield a 150-percent or greater profit for that same $5 rise in the underlying stock (if the call value rose to $5 or more).
The other side of this coin is a higher percentage loss can occur with owning a call (compared with owning the stock). Percentage losses of 50 percent or more can quickly accumulate if the earnings report is disappointing or the stock fails to react positively to better-than-expected earnings. A 50 percent decline on a $2 option, however, is only around $100 per contract. In fact, if the option lost 100%-which could occur if the stock had a huge decline or if the option expired worthless-would only be $2. (Typically with earnings trades, options are only held a few days and the option expiring worthless is not a concern).
The potential advantage of buying options lies in the volatility of the underlying stock. On a big move higher, options can book a higher percentage profit; for a move lower, they have less absolute risk than the underlying stock (though percentage declines can be greater). When greater volatility is anticipated, buying options might be a winning alternative to buying stock. But it might not.
Sometimes traders run into trouble trading options around earnings. Sometimes option trades don't work out as planned - even if the underlying stock moves as anticipated. Chalk this up to the volatility component of option prices.
The Rush and the Crush
Sometimes ahead of a firm's quarterly earnings announcement, the company's options can get more expensive as hedgers and speculators create demand ahead of anticipated volatility. Investors and traders buy options for protection and to make directional bets before the announcement. This pushes up option prices - often referred to as the volatility rush.
When unusually high volatility is anticipated, option prices can rise to much higher-than-normal levels. The at-the-money call trading at $2 in the last example might trade for $4, $5, or more thanks to higher volatility.
After the earnings announcement, hedgers no longer need protective option positions and speculators sell their options to book profits or losses. This creates supply pressure, causing option prices to fall. This is called the volatility crush. Sometimes the crush of the volatility component of option prices can have a greater effect on the option's price than stock price movement. That means it is possible for the stock price to rise but the call price to fall.
The problem that can arise from this scenario is for would-be call buyers positioning for the earnings announcement. This additional risk factor - the volatility component of the option's price - needs to be considered. If option premiums are too expensive, a trader may not want to buy options. In fact, if premiums are really expensive, a trader may want to sell options.
Selling a Put Spread Before an Earnings Announcement
Another way to take a bullish position in a stock using its options is to sell a put spread. A put gives its buyer the right to sell 100 shares of the underlying stock at the strike price on or before the expiration date. A put seller has the obligation to buy stock at the strike price if a put owner exercises his or her right and the short put is assigned.
Selling a put spread involves selling one put and buying another with the same expiration date but a different strike price. A trader might choose to sell a put spread instead of buying a call if premiums for the stock's options are unusually high. But there are some important differences between the two bullish plays.
Let's use the same stock as in the previous example. The consensus estimate for earnings is 20 cents, the whisper number is 22 cents, and a trader believes the actual earnings number will exceed both. But say that this time, option premiums are elevated. It would cost $4.50 to buy the same short-term, at-the-money call. Instead, the trader decides to sell an at-the-money 50-strike put with the same expiration month for $4 and buy an out-of-the-money 40-strike put for $0.75. This spread results in a net credit of $3.25.
The hope here is also for the underlying stock to rise on earnings. With long options, the maximum risk is the premium paid; with short options, the maximum gain is the premium received. In other words, the maximum profit for selling a put spread is equal to the net premium received. That means no matter how high the underlying stock rises, the most this trade can profit is $3.25.
If the trader is wrong, and earnings are worse than both the whisper number and the consensus estimate, the stock price could decline, maybe a lot. In that case, the put spread could end up a loser. With a short put spread, the maximum loss is limited to the difference between the strike prices minus the net credit. In this case, the maximum possible loss is $6.75 per contract.
Choosing the Right Option
A trader must balance some key bits of information. First, the trader must consider how big of a stock-price increase he anticipates and weigh this against the expense of the option. For bigger moves, buying calls might be a better strategy because calls continue to profit as the stock rises. Smaller anticipated moves may be better served with a put spread.
High-premium options resulting from the volatility rush may be worse for buyers as the trader must pay more and risk the volatility crush adversely affecting the trade. Option selling might be better as short options benefit from declining premiums. The option premium also needs to be weighed against the potential for a stock-price decline after earnings.
For situations in which the possibility for a large stock decline exists if earnings are worse than expected, traders should factor in which strategy has less absolute risk. In many cases, buying a call will be a lower absolute-risk trade than the bull put spread. For situations in which the perception of downside risk is less of a concern, selling a put spread may be a better play because the potential benefits of a volatility crush could outweigh the adversity of a dip in the share price.
When the whisper number is significantly higher than the consensus estimate, it might suggest the potential for a more volatile move on earnings. If the actual earnings number is above the whisper number, a strong bullish move might follow as the market reacts. If the actual earnings number is below the consensus, the stock could plummet as the over-confident masses sell off their holdings.
If there is not a volatility rush factored into option premiums, buying a call might be a better deal for an earnings speculator. Why? In this higher-risk scenario, call buyers can have less downside risk and higher upside potential than a put-spread seller. Without a volatility rush, call buyers don't have to pay extra for this dual benefit. Selling a put spread is less attractive without the richer premiums associated with a volatility rush.
Summary Thoughts
These are just a few of the potential trading strategies that can be used and ideas to keep in mind when using options to trade earnings announcements. When implementing strategies like these it is critical to remember that they are only as good as the underlying information they are based on. In the case of implementing an option-trading strategy based on an expectation for a company's earnings, it is critical to have the best possible information as to what the market expects those earnings to be. Even the best strategies are doomed to fail without the right information.
Written by Dan Passarelli, Optionshouse.com
Dan Passarelli is Director of Education for OptionsHouse, Inc. which provides retail investors with online trading at a low, flat fee of $9.95 per option trade and $4.95 per stock trade, regardless of size, through its website, www.optionshouse.com . He has been involved in the derivatives industry since 1993. Dan started his trading career on the floor of the Chicago Board Options Exchange (CBOE) as a market maker trading equity options. Dan also traded agricultural options and futures on the floor of the Chicago Board of Trade (CBOT).
In 2005, Dan joined CBOE's Options Institute, as an instructor teaching both basic and advanced trading concepts and techniques to retail traders, brokers, institutional traders, financial planners/advisors, money managers, and market makers. In addition to his work with the CBOE, Dan taught traders options strategies at the Options Industry Council (OIC). His classes at CBOE and the OIC were taught in person within the U.S. and abroad, and were syndicated internationally via webcasts and podcasts. Dan has been featured on television and radio, and has written numerous articles for magazines and other periodicals. He is author of the book Trading Option Greeks.
Options involve risk and are not suitable for all investors. In addition, electronic trading poses unique risk to investors. System response and access times may vary due to market conditions, system performance and other factors. OptionsHouse provides neither investment nor tax advice. Please read Characteristics and Risks of Standardized Options | Risk Statements and Disclosures, a copy of which can also be obtained by contacting the Optionshouse.com Customer Service Department at (877)653-2500 or at customerservice@optionshouse.com.
