Trading Options Around Earnings Announcements
For years and years clients of mine asked if I could teach them how to effectively trade around earnings announcements. And for years and years I stated: No!
At the time, there were only 12 expiration cycles per year. Each expiration occurred on the third Friday of the month, so it made it hard to trade earnings announcements with any real precision.
But oh, how things have changed.
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The advent of weekly options was a game changer.
Now we have the ability to trade earnings announcements with far more precision.
There are three strategies that I prefer to use around earnings: short strangles, short straddles and iron condors. Due to the defined-risk nature of the iron condor, I’m going to start with iron condors today and move on to short strangles and short straddles over the coming days. I’ll also be including trade ideas several times each week as we move through earnings season. Stay tuned!
Implied Volatility
Professional and retail investors look to hedge and speculate around earnings. As a result, demand for options typically spikes. And with that spike in demand comes a spike in implied volatility (IV) in the expiration cycle that falls after a company announces. But most important is the spike in options prices due to the heightened volatility.
It’s like clockwork. We know it’s going to happen; we just don’t know how high a company’s IV will be from one quarter to the next. This is where a methodical approach is helpful. It gets you into trades that give you the best opportunity for profits and keeps you out of trades where the odds aren’t in your favor.
The Law of Large Averages
Earnings season trades are binary, one-day trades. The price movement after an announcement either stays within the expected range or pushes outside of the range.
In most cases, each trade I place has, at least, an 80% probability of success. As a result, we know that as trade occurrences increase our win ratio should fall right around 80%. I traded this strategy successfully for over three years with over 100 trades and guess what my win ratio was: yep, just over 80%. There is a reason why the Law of Large Numbers is, well, a statistical law, right?
But, just because you have a high win ratio doesn’t mean that you are going to be successful over the long term. I’ve known plenty of traders with high win ratios who still lose money hand over fist.
Risk management, as with any investment strategy, is a necessity. And because these are one-day trades, the only true way to manage risk is through using a disciplined and consistent approach to position size. Every one-day trader will have different levels of risk when using the strategy; I try to keep my position size between 1% and 5% per trade. By keeping my position size at reasonable levels I am able to endure sequencing risk and can focus solely on the end goal … allowing the number of my trades to increase so the Law of Large Numbers has the ability to play out.
From there, I use the following five-step approach to trade earnings:
Step 1
The first aspect of placing a trade is knowing if the underlying of your choice has adequate liquidity.
Most traders don’t realize, but there are only 3,200 tradable stocks with options. Only 11% out of the 3,200 stocks have medium liquidity and only 3% are considered highly liquid.
With just a few exceptions, I only focus on the 3% of highly liquid stocks.
At the end of each week during earnings season, I prep a list of the upcoming earnings announcements for the coming week.
Step 2
The next step includes looking at the IV rank and IV percentile.
*IV Rank – tells us if current implied volatility (IV) is considered high or low on an underlying security in comparison to all other IV readings over the past 12 months.
IV rank is calculated by taking the highest IV reading and lowest IV reading over the past 12 months.
Current IV – 1 Year IV Low
1 Year IV High – 1 Year IV Low
For example, if a stock has an IV range between 40 and 80 over the past 12 months and the IV is currently 60, the stock would have an IV rank of 50%.
*IV Percentile – tells us the percentage of days that implied volatility (IV) has been below the current level of IV over the past 12 months.
IV percentile is a ranking system from 0-100.
For example, if a stock has a current IV percentile of 80%, it simply means that the current level of IV is higher than 80% of all IV readings over the past 12 months.
Understanding the difference between the two and how to effectively use each measure is important, not only during earnings season, but also outside of earnings season.
When I am trading around earnings, I use both measures and typically want to see a reading around 50%, if not higher.
Step 3
Once I’ve found a candidate with an acceptable IV rank and IV percentile, I then move over to my platform to take a look at the expected move for the stock. For the most accurate reading I look at the nearest-term expiration cycle.
For example, if a stock is due to announce earnings after the close on a Tuesday, I want to look at the expected move for the expiration cycle that Friday.
There is one exception: If a stock is due to announce on a Wednesday through Friday, I will take a look at the expiration cycle one week out.
Step 4
After I know what the expected move is, I move on to the historic price movements around the last 12 earnings cycles and compare them to the current percentage of the expected move. I also look at the Earnings Volatility Ranking (EVR).
EVR is ranked from 1 to 10, with one being the least volatile around earnings and 10 being the most volatile around earnings. Knowing if the EVR reading is high or low gives me the insight to which strategy I will use.
Step 5
If my potential candidate meets all the aforementioned criteria, I swiftly move over to my strategy. I almost always use risk-defined options strategies like bear call spreads, bull put spreads and iron condors when I place earnings season trades. However, I like to use undefined-risk strategies like a short strangle or short straddle as well, particularly the short strangle as it gives me the highest probability of success.
Overall, I would say iron condors are my favorite strategy to use. If you are not familiar with the iron condor strategy, please make sure to read my report on this powerful, neutral-based options strategy.
The Strategy
The basic premise of my iron condor is simple. I place the range of my iron condor outside the range of the expected move.
For example, if Walmart (WMT) has an expected move between 140 and 155 I want the short strikes of my iron condor to be outside the range. In fact, I want a range as wide as I can possibly go while maintaining the ability to make a reasonable profit.
Moreover, I want my probability of success to be greater than 80% on both the call side and put side of my iron condor. I aim to make a return anywhere from 10% to 35% per trade.
I’ll be going over several examples in far greater detail in an upcoming video…stay tuned!
Quick Summary
Earnings season offers some tremendous profit opportunities.
During each earnings season I will provide weekly tables on the highly liquid stocks you should be focusing on. Moreover, I will provide additional research and trade ideas several times throughout the week. Stay tuned!