Earnings season is right around the corner, with big banks set to report starting next week, and tech to follow soon after. We know it can be enticing to trade options during earnings, and sometimes it can be a great idea. However, if you’re going to trade options during earnings, there are a few things you should know.
Here’s the first caveat: Trading options ahead of earnings is a high-risk, high-reward endeavor.
The Pros of Trading Options Through Earnings
On one hand, many of the biggest option gains you might see being boasted about on social media come from successfully predicting above-expectation earnings moves, often using out of the money puts and calls to leverage cheap options against a big catalyst.
As an example, imagine stock $XYZ is trading at $50 ahead of its earnings. You choose to buy put options at the $40 strike expiring immediately after the earnings take place, for $0.50 per contract. On the release of the earnings, the company drops a bombshell — a big earnings miss, an even bigger guidance miss, and maybe some extraneous bad news as well. The following day, shares of the stock plummet to $30 per share. Suddenly, your $0.50 options are worth an intrinsic value of $10.00 per contract — a 20X gain overnight. Had you spent $5,000 on the options, you would be sitting on a new trade value of $100,000 — plus any extrinsic value that went along with those options.
While it can be difficult to identify these opportunities, they do happen.
However, there’s a flip-side to that coin.
The Cons of Trading Options Through Earnings
Holding options through earnings exposes traders to a phenomenon called IV crush. IV crush occurs because, put simply, the options market isn’t stupid. It knows that earnings events have a likelihood for producing above-average market moves. So the options market prices these options at a higher premium in an effort to “price-in” the earnings move, causing an increase in implied volatility, or “IV.” Basically, this means options are usually more expensive when bought before earnings, relative to options bought after earnings.
However, on the day following the release of the earnings, the “surprise” catalyst is no longer there — and subsequently, the IV will often rapidly deplete. This could cause your options to lose value even if you’re right about the directional move of the stock, if it doesn’t move far enough past your long option’s strike price to account for the amount you paid.
As an example, imagine the same stock, $XYZ, which is now trading at $30, is gearing up for yet another earnings event. You attempt the same strategy as before — a $20 strike put option expiring immediately after the earnings event. You pay the same premium — $0.50 per contract. And once again, you’re directionally correct — $XYZ releases earnings that disappoint the market. However, this time, $XYZ falls to just $25. That’s still a big downside move for a stock of that value. Unfortunately, when you wake up the next morning following the drop to check on the price of your option, you’re left unsatisfied — the IV that was bolstering the premium of your $20 strike put has now been put through IV crush. With little time remaining in your option, and no other known catalysts for the stock within the life of your option, you may very well have a worthless, unsellable option when you wake up that morning.
This phenomenon often catches new options traders off guard, but even the experienced can fall victim to IV crush, or simply missing the direction of the earnings move entirely. Both are serious risks when considering an earnings trading using options.
The Moral of the Story: How to Trade Options Through Earnings
Here are three earnings trading strategies that may save your account when attempting to trade options during earnings events:
Option Position Sizing for Earnings
At Market Rebellion, we’ve always been a fan of the 1% rule. That means we don’t like to stake more than 1% of our account value on any individual trade. If we lose, we can still carry on and fight another day. If your account is smaller, it doesn’t have to be 1%. Maybe for you, the number is more like 5%, or 10%.
Whatever the number is, stick to it, and don’t risk your entire account on a single event. It’s not worth being blown out — and there will always be another trade idea. In short: If you’re making an earnings trade, be prepared to potentially lose whatever you’re risking.
How to Set Price Targets for Earnings
There are a variety of ways traders calculate price targets for earnings stocks. For instance, you might use the average move of the stock following earnings. That’s an easy one — simply research what the stock did during the last several earnings, add them all, divide by the total number of values, and apply that percentage to the current stock price. While this won’t necessarily help you from a directional perspective, this gives you a more honest depiction of what the implied move “should be,” which is often different from what the options market is pricing in. This can also help you to choose an appropriate options strategy for the situation (more on that in a moment).
Another way that traders calculate potential price targets is by identifying prior points of support and resistance. You can do this by drawing flatlines across consolidation points in a stock, looking at moving averages that the stock has respected in the past, or even using advanced charting techniques like Fibonacci retracement.
One final way that many of us at Market Rebellion like to identify potential price targets is to monitor options order flow for unusual options activity. Simply put, you’re letting the institutional traders do the work for you in this strategy. This is probably the “easiest” strategy to follow, because the institutions are already selecting the options strategy, strike price, and entry point. Why do we believe in UOA? It’s pretty obvious: Someone out there is making a prediction, and they’re putting their money where their mouth is. If you’re staking a million dollars of your own money on a specific prediction, you’re probably doing your research.
Curious what institutional option trades we’re seeing ahead of earnings season? Try a month of UOA trade ideas below.
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Advanced Options Strategies for Earnings
The risk of trading options during earnings usually revolves around volatility. Lucky for you, there are options strategies that help mitigate that risk. Each of them come with different use cases. For instance…
Imagine you’re bullish on a stock’s earnings. The stock is trading at $100. You could buy a long at-the-money $100 strike call in the stock for $5.00. Or, you could buy a bullish call debit spread.
To enter a bullish call debit spread, you would still purchase the same long call, however, you would simultaneously sell short a further-from-the-money call.
Let’s imagine you sold the $110 call, and that it nets you a premium of $3.00. That means the total cost associated with entering your bullish position is $2.00. Why? It’s the $5.00 you paid for the long call, minus the $3.00 you received for selling the short call.
Here’s what changed when you swapped from a long call to a call debit spread:
- Implied Volatility Risk. By their nature, long options are positive vega. That means when implied volatility rises, long options gain value. When implied volatility falls, long options lose value. By adding a short option to your trading strategy, you are balancing out some of this IV crush risk. You’ll still be long vega at the end of the day, because the delta of your long option is higher than the delta of your short option, but this strategy still helps to mitigate some potential losses.
- Theta Risk. The same idea above is true here. Theta eats away at long options as time ticks by. Conversely, theta is the bread and butter of short options. Having a short option in your strategy helps to balance out theta risk in the same way that it balances out the risk of IV crush.
- Cost and Breakeven. An option’s “breakeven point” is the point at which your option becomes intrinsically profitable to you. It’s easy to calculate — just take the value you paid for your option strategy and add it to the long strike of your bullish trade, or subtract it from the long strike of your bearish trade. In the instance shown above, the breakeven of a $100 strike call bought for $5.00 is $105. For every penny that the stock ticks above $105, you’re making one real dollar of value on top of the $5.00 you paid. Conversely, for the call debit spread shown above, the breakeven point is $102. You paid $2.00, and the long strike price is $100. Having a lower breakeven can potentially increase your odds of having a profitable trade.
- Max Value. Here’s where the long option wins out. Long calls have theoretically infinite profit potential — and long puts have profit potential worth 100 * the strike price you selected – the price you paid. Conversely, debit spreads have a capped maximum value. You cannot continue to gain value beyond the short strike you select. In the instance above, your $100/$110 debit spread will not change in value whether the option expires with the stock trading at $110, or $210.
- In that example, for the long call option to be more profitable by percentage than the long debit spread, the stock would have to surpass a value of at least $125. That’s because the $2.00 you paid will reach a 5X value in a perfect scenario, where the stock closes at or above $110 by expiration. A 5X for the $5.00 long call would mean a value of $25.00 — add that price to the strike of your long call, and you get $125. Of course, if the stock does make that rally all the way up to $210, you would be glad you were holding that long call.
Long debit spreads aren’t the only strategy options traders use for earnings. There are several short-volatility strategies that are popular among options traders.
Some of those include short iron condors (which aim for stocks to trade within a range between the strike prices in order to achieve max value, and benefit from shrinking volatility), and credit spreads (which are in essence a short debit spread, and benefit from the debit spread expiring worthless).
One more popular strategy into earnings that balances both sides is called a diagonal spread, which is just like a debit spread — except the short leg is sold at a nearer date than the long leg is bought. Because near-term options are exposed to higher levels of theta and can be more easily crushed by implied volatility, this can create a “best of both worlds” scenario where traders can lower the cost of a long option, benefit from potential gains, and still be short some volatility. However, diagonal spreads carry a new risk — if the stock dramatically overshoots your short strike, you could still end up losing the entire value of what you paid for the diagonal spread. Debit spreads and credit spreads do not have this “overshoot risk.”
Which strategy will work best often depends on the situation. If volatility is very low, or you’re expecting a truly massive move, a simple long option may be the best choice — if you can’t sell a reasonable short option against it, why cap your potential gain? If volatility is running on par with what’s average for an earnings event, or you’re expecting a modest move, a debit spread or diagonal spread may be the right choice. If volatility is running high, you might consider a strategy that benefits from its potential fall, like a credit spread or a short iron condor.
Whatever you choose, remember, there isn’t a best option strategy for trading earnings. Think of option strategies more like tools. Certain tools are great for certain situations — but you need to master them all in order to do the job right. After all, you wouldn’t try to renovate your kitchen using just a hammer — and you shouldn’t try to trade all earnings with just a single option strategy.
Wrapping Up: How to Trade Options Through Earnings
By now, hopefully you realize that trading options through earnings isn’t an exact science. It carries higher than average risk, and there are a lot of extraneous factors to consider. However, when the time is right, and the stars align, earnings can present some of the most profitable option trading opportunities available in the stock market.
By arming yourself with knowledge about how to pick the right options strategy for earnings, how to measure price targets for earnings, and option position sizing for earnings, you’re giving yourself an edge that many other traders are missing out on.
Want to turn these tips into actionable trade ideas? Talk to a professional options trader for free today.
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