Option Strategies for Earnings Season

Buy a stock just before its earnings report is a bet: it can be highly profitable or devastating for your portfolio. You decide the risk you face. I always prefer to wait for the report, to compare their numbers with the estimates in EPS, sales, and guidance, review the conference call for some additional data and see the next day analyst's ratings, which usually increases or decreases their weighting and price target. And, of course, you can use specific options strategies during these events. Let's overview some ideas as to choose the right strategy. You need to know the following principles:

-  A strategy that involves long options (been calls or puts) will typically gain value as IV increases (its premium increases) and lose value quickly with IV decreases.

- On the contrary, a strategy that involves short options (been calls or puts) will typically gain value quickly with IV decreases (its premium decreases) and lose value as IV increases.

- During an earnings event, the implied volatility IV of the underlying usually increases some days before the report (due to typical great attention given by traders, creating orders like bets). And when the report was released it drops sharply.

Thinkorswim includes this great feature in its platform, in which, at a glance, you could review the latest earnings of any stock, in this case, Disney DIS, showing its price move and implied volatility before and after the event. 

Here is an example of what usually happens during an earnings event: despite the result (if the stock beats or miss EPS, sales or guidance), the implied volatility increases before the earnings date, and decreases quickly after it, the next day, hurting the premium. A similar behavior have the ATM straddles. The goal is to take advantage of this movement.

1. Trader's  favorite bet on earnings: Buy OTM Call/Puts

If you decide your directional bias in the underlying near the earnings report, buy OTM calls (or OTM puts, depending on the direction) just before it, with cheaper premiums, looking for a big profit if the stock explodes after the report. It also works with spreads (OTM credit puts or OTM credit calls) for bullish or bearish bias, respectively.

Novice traders love this simple "strategy"(really, it's a bet): low-cost, minimum risk but also very little profit probabilities in your favor. Is Robinhood users' favorite strategy, by far, in 2020. It's a perfectly valid strategy, that few I use: due to my management risk rules, I prefer a debit call spread. I review company data available: last earnings performance and surprises, latest news and analyst' ratings, traders sentiment, short-interest, recent insider trading, etc. And I clearly understand that no matter how much I analyze it, as it's a bet, it only sometimes works. A roll's dice.

2. Expecting large moves: use Straddles/Strangles

Other traders expect a huge move in stock price and a volatility spike after its Earnings Report, but can't decide what bias take, bullish or bearish. In this case, they play straddles and strangles spread strategies to take advantage of either scenario. A large move is what is needed here, the direction isn't important.

A Straddle requires buying an ATM call option and an ATM put option. Both at the same strike price.
A Strangle requires buying an OTM call option and an OTM put option. Strike prices can differ.

You have to wait for a large breakout in either direction after the event. If none occurs, close the spread after a predetermined time.

Typical P/L (profit/loss) chart of an ATM straddle, in this case of Intel INTC with expiration in September. Your first analysis is notice you paid $2,640 for 10 options and you need at least a 10% move on stock price to be profitable. 
A popular strategy is to buy ATM straddle, the closest, 5 days before an earnings event and sell it one day after, taking advantage of price and volatility strong change. 

As you verify in the chart above, a straddle/strangle has interesting features against other option strategies. Let's summary them:

- Maximum profit: potentially, unlimited profit on either side of the market.

- Maximum loss: limited to the net amount paid for the spread.

- Risk level: limited to the combined premiums paid for the call and put options. For straddles is better to use ATM strikes. For strangles, I prefer to buy from 1 to 3 strikes OTM, depending on support/resistance levels. A non-volatile non-directional move is the least desired outcome.

- Environment: ideal when you expect a significant breakout of price in any direction, due to the next earnings reports or explosive company news. Timing in the last case is key.

- Stock volatility: if increases, works in your favor, as option premiums for both calls and puts rises.

- Implied Volatility: in terms of cost, for low IV, buy straddles/strangles. For high IV, sell straddles/strangles.

- Time decay: is negative as it works against both strategies. 

- Close position: as other options, this spread could be closed at any moment, better prior to expiration when reached your target at a support/resistance level. As breakout occurs in one direction, you can close the other side leg, or look to hold in case of a pullback. Traders profiting with this strategy close half position when premium paid doubles in value, leaving the remainder for further gains.

- Expiration Risk: if you use this strategy for a specific high-volatility event as earnings it's better to choose short-duration options. If you are afraid of time decay, use 2-3 months expirations to mitigate it.

3. Using Volatility change

If you have a neutral position or presume the underlying wouldn't have a sharp move before/after the earnings report, you could consider taking advantage just from volatility changes:

- Before earnings: entry long positions (long calls, long puts or ATM debit spreads) one or two weeks before earnings day, and then closing the position the day before the event, so to take advantage of the volatility increase mentioned above.

- After earnings: entry short positions (short calls, short puts, or ATM credit spreads) just before earnings, to take advantage of the volatility decrease mentioned above. The position could be closed just after the report.

As you see in the three option "tips" mentioned in this post, risk management is the main factor I consider in all of them.  Protect your portfolio and protect your gains is the key to become a profitable trader.

Good Trading!

@BravoTrader

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