Trading options before earnings

Should you even be touching Options before binary events like earnings?

Chapter taken from my book: “25k Options Challenge” (https://25k.link/book)

I have mentioned in my book that I do not trade earnings at all due to the binary nature of the event. Earnings are absolutely unpredictable! Irrespective of whether earnings are good or bad, the market’s reaction is almost impossible to gauge.

So, does this mean that during earnings season, one should not trade at all? In my opinion, staying engaged in the market is very important and earnings should not be a reason for you to stay away from the market. Have you ever noticed that once you put on a position in a stock, you suddenly find yourself reading all the news surrounding that stock and are suddenly more knowledgeable about that company, even if it is a short term position? “Being engaged in the market” or having “skin in the game” is very important and earnings season shouldn’t be a deterrent for you.

You will notice that most companies report their earnings within the same month (at the end of the quarter). Yes, there are some off-cycle companies too, but most of the earnings fall during the same months. Earnings season generally occurs in the month immediately following the end of each fiscal quarter. This means that earnings seasons typically fall in January, April, July, and October.

Now, the question is – How can you keep trading during earnings and still avoid binary/gambling type events? Here are a few ways of doing it:

PRE-EARNINGS – Switch to ETFs and Indexes – One way of avoiding individual stocks during earnings is to simply switch to Indexes and ETFs. A very nice feature of debit spreads is that irrespective of the price of the Equity or Index, debit spreads always cost the same. So, if you are buying an at-the-money AAPL $100 – $110 bull call debit spread or you are buying an at-the-money SPX $3000 – $3010 bull call debit spread, they will cost you exactly the same money (approx.. half the width of the strikes. i.e $500 in this case). I usually switch to Indexes/ETFs when earnings are coming up in the next 30 days. The Indexes and ETFs do react to individual earnings but the reaction is buffered. So, if GOOG reports bad earnings, you will see that reflected in NASDAQ (QQQ or NDX) but the reaction will be cushioned.

AT-EARNINGS – Taking advantage of Implied Volatility – If you have read any primer on Options, you will notice that one of the components that decides how much an Option costs is Vega or Volatility. Just before earnings, the Vega component (or Volatility) of an Option goes through the roof. This is because of the unpredictable nature of earnings. Think of it this way – Why would an Option seller sell you a Call or Put Option on a stock if they know they can get wiped out if the stock goes against them when earnings are announced? To protect the seller of an Option from taking that huge risk, the Options premiums increase dramatically just before earnings. The premiums are at their highest just the day before earnings

TIP: Another way of understanding this would be by taking the example of a hypothetical insurance company called EveryState LLC. If John who is 50 years old, has a stable job, is married with a family of 4 and has not had any accidents in the last 5 years, goes to buy insurance from EveryState LLC, they will see him as a low risk driver (compare that to a stock which doesn’t have earnings and is slowly chugging along its normal trading channel with no surprises in the horizon). In this case, John is the premium buyer and EveryState LLC is the premium seller. Contrast this with John’s son Kevin, who just turned 16, has no driving history, is an unpredictable teenager with no stability in life. If he goes to buy premium (compare that to buying a Call or Put), Kevin (actually it will be his Dad in this case) will have to pay through his nose for that. The same thing applies to Options. When earnings are around the corner, Calls and Puts become very expensive due to the unpredictable nature of the earnings event.

Once the earnings are released, the surprise factor is gone and the premiums get deflated instantly. This is also called “IV implosion”. Many Call/Put buyers are left wondering after earnings why they lost all their money even if the stock goes in the direction they were betting. The IV implosion drains all the juice out of their Options causing a dramatic loss in value.

The best way to take advantage of the IV implosion is to sell an Option instead of buying it. You can simply sell the extremely inflated Option on the day before earnings and buy it back for cheap immediately after earnings are announced. There are strategies like selling Strangles and Iron Condors which are designed to take advantage of the IV implosion which I will talk about later.

POST-EARNINGS – Continuation Trades – Earnings cause a complete reset in a Stock’s personality. Due to the “surprise factor” or unknown nature of the earnings event, you will notice that after earnings are announced, the stock spikes up or down sharply as the market digests the earnings announcement. A Stock like BKNG or GOOG can spike up $100 – $150 in a day when earnings are announced. What you need to remember with earnings is that you have to respect the direction of the initial spike. If it is a huge up or down move, it has happened for a reason as the market digests the earnings numbers.

You will also notice that in the days following earnings, the stock pulls back or normalizes a little after that initial spike as the market assimilates the news and reflects it in the stock’s price. This is the time to look for “post-earnings continuation trades”. With these kinds of trades, you need to put on a trade whose directional bias matches that initial spike. Eg. if GOOG spiked up $150 after earnings announcements, you may see that in the 3-10 days following earnings GOOG pulls back maybe $70-$100. This is the time you would buy a Bull Call Spread. Notice that this is completely opposite of my regular mean-reversion trades. For post-earnings trades, you wait for a pullback and have to take a trade in the original direction of the post-earnings spike. For these trades, my usual technical indicators like ADX, RSI, Bollinger Bands etc, don’t apply. You can use the simple concepts of Support and Resistance to find these trades. I will explain this with an example later in this book.

As I have mentioned in the previous chapters, due to the binary nature of earnings, I don’t trade earnings at all. But that doesn’t mean you should stay away from the market during earnings season. Instead of trading pre-earnings, I put on post-earnings trades instead. Once earnings are done, the “surprise factor” is gone and it is much easier to find trades after the fact.

In this chapter, I will be walking you through some of my favorite post-earnings trade setups with examples. These are real trades which I take in my own account.

There are ways of trading pre-earnings too. Selling Strangles and Iron Condors are very popular and I will show you an example of that as well. I don’t do these types of trades in my $25K challenge account due to the small size of my account, but I do them every now and then in my larger discretionary account.

Exploiting Inflated IV (An Iron Condor Trade)

As the earnings date starts approaching, the Vega component of a stock (IV), keeps increasing. For highly liquid stocks, platforms like ThinkorSwim can use this IV to calculate how much the market is pricing the stock to move when earnings are announced. This number keeps changing until the last day before earnings are announced.

Can you think of a way how to exploit the inflated IV and the fact that you are able to see with a decent level of accuracy, how much the stock might move after earnings?

The basic rules of trading apply here. Buy low, sell high! In this case, the Implied Volatility (IV) is highly inflated, so the best trade to take would be to sell an Option when it is inflated in value. After earnings are announced, the “surprise factor” disappears which causes a dramatic implosion in IV, and that causes the Option prices to drop in value. When this happens, we simply buy back the Option we sold for cheap.

There are many ways of doing it. You will hear traders selling Straddles, Strangles and Iron Condors. The trade I will show you is the Iron Condor as it is suitable for smaller portfolios because the risk is defined. Straddles and Strangles are suitable for larger accounts as they have unlimited risk and tie up a large amount of margin in your portfolio.

Setting up the Iron Condor

To demonstrate this, let us take DPZ as an example which was trading at $431 at market close on 10/8/2020. It has earnings coming up before market open on 10/09, and the expected move (MMM) is showing $22. I had mentioned earlier that if you pick highly liquid stocks, the expected move calculation is fairly close to accurate. Of course, there is never a guarantee and there are always outliers, but this number gives a good gauge of how much the stock will move up or down after earnings.

Now that we have a decent idea about how much the stock might go up or down, the only unknown left would be which direction the stock will go after earnings.

In Chapter 8, where I had introduced Credit Spreads, I had demonstrated selling a GOOG put credit spread. We were bullish on GOOG and we had sold a Put at a strike price where we thought GOOG could not possibly drop down to. We then simultaneously bought another Put below that to protect ourselves in case GOOG does go down due to some unexpected event.

Coming back to our DPZ example, the stock is trading at $431, and the Options market is pricing the expected move to be -+$22 (seen as the MMM number in ThinkorSwim). Let us add some more buffer to this for our safety and pretend that the stock market is predicting a $25 move instead. Based on this information, we could sell a $405-$400 PUT Credit Spread for $1 (also known as a  Bull Put Spread), 2 hours before Market close. Note that you should always choose the closest weekly expiration for pre-earnings Iron Condors. By selling the spread near market close, we take advantage of IV being at its highest before earnings are announced. This would bring us $100 in premium. We would be risking $400 to make $100 for this trade with the probability of us winning at almost 80%.

The beauty of this credit spread would be that tomorrow morning, when the markets open, if the stock stays above $405, we can immediately buy back the Credit Spread for .20c.

That is how fast IV implosion drains the juice out of these spreads. I have done this many times and it is a really fun experiment to watch how Option values can deflate so quick.

But wait! Where is the Iron Condor here? This is just a Credit spread, right? To construct an Iron Condor all we need to do is sell a CALL Credit Spread, in the exact same fashion we sold the PUT Credit Spread. So, with the stock trading at $431 and the market predicting a $22 move, we simply add some buffer for our safety and sell a $455-$460 Call Credit Spread at the same time as we are selling our Put Credit Spread. We can bring an additional $100 by doing this.

The beauty of all this is that our risk still stays at $400. The risk doesn’t double to $400 (for the PUT side) + $400 (for the CALL side) = $800. Why is that? The reason for that is, a stock can either breach your short Call or your short Put. It cannot breach both at the same time. This keeps your risk the same i.e $400, but now you are bringing in double the premium as opposed to what you would have got if you were simply selling either just a CALL Credit Spread or just a PUT Credit Spread. Pretty neat right?

In this particular trade, we risked $400 to make $200 with 80% chance of success. Plus, the trade can yield fruit in a single day.

NOTE: In most trading platforms, you can (and should) sell the Iron Condor as a single trade. You don’t need to sell the put spread separately and the call spread separately.

The order entry screen from ThinkorSwim below, shows you an example of a DPZ Iron Condor where we are selling a $455-$460 call spread and a $405-$400 put spread at the same time which will bring us $200 in credit.

I did mention that this trade has a 80% chance of success. How did I know that? If you scan any options chain, you can see that number yourself. Just look at the probability OTM column which shows you what is the chance of any Option expiring worthless. In ThinkorSwim, Probability OTM column will help you pick out which strike to sell short for both the CALL and the PUT side. 80% OTM probability usually corresponds to 15 to 18 delta. You can use either of these columns to help you pick out your strikes. I have shown an example using DPZ (Dominos Pizza Inc) which demonstrates this.

The next image shows how the risk/reward graph for a Short Iron Condor looks like (short meaning you are selling the Iron Condor).

Notice that if the stock stays between $405 and $455, you make your full money. You will start losing money if it breaches your strikes, but your losses will be capped again at the long strikes you bought for your protection.

Risk graph for a typical Iron Condor

Risk graph for our DPZ Iron Condor

The next day DPZ dropped hard due to missed earnings. It opened at $405.9 almost exactly at my short strike, which shows you how accurate the Options market can sometimes price these earnings moves.  With earnings condors, it is very important to buy back the Iron Condor immediately at market open for .20c or .25c, Next morning at market open, the Iron Condor which I had sold for $2, was trading at $2.95 (i.e a loss), but DPZ traded all the way up to $410 that day and I was able to buy it back for .20c.

Also note that, had I waited another day trying to milk out the .20c, this would have been a full loser. DPZ fell all the way down to $385 the next day and never came back above $402. With my options expiring on Friday, I would have had no chance of getting out at break-even or any kind of profit.