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Trading stock around the times of earnings releases
is a notoriously difficult operation because it requires accurate prediction
of the direction of price movement. Wrong predictions can expose the trader
to substantial loss if large unexpected moves occur against his position.
Because of
the risk associated with these events, many traders use options to define
their risk and protect their trading capital. The purpose of my missive today
is to present several approaches to using options to capture profits during
the earnings cycle and to help present the logic and call attention to a
major potential pitfall of using these vehicles in this specific situation.
It is
essential to recognize that as earnings announcements approach,
there is a consistent and predictable pattern of increase in the implied
volatility of options. This juiced implied volatility reliably collapses
toward historical averages following release of earnings and the resulting
price move.
A real
world example of this phenomenon can be seen in the options chain of AAPL
which will report earnings tomorrow afternoon. The current options quotes are
displayed in the table below:
AAPL
Option Trade
Notice the
implied volatility labeled as MIV in the table above for the 605 strike call.
The volatility for the front series, the weekly contract, is 59.6% whereas
that same option in the September monthly series carries a volatility of
28.3%.
This is a
huge difference and has a major impact on option pricing. If the weekly
carried the same implied volatility as the September option, it would be
priced at around $7.70 rather than its current price of $16.50!
The value
of the implied volatility in the front month options or front week options
allows calculation of the predicted move of the underlying but is silent on
the direction of the move. A variety of formulas to calculate the magnitude
of this move are available, but the simplest is perhaps the average of the
price of the front series strangle and straddle.
In the case
of AAPL, the straddle is priced at $33.80 and the first out-of-the-money
strangle is priced at $28.95. So the option pricing is predicting a move of
around $31.50. This analysis gives no information whatsoever on the
probability of the direction of the move.
There are
a large number of potential trades that could be entered to profit from the
price reaction to earnings. The only bad trades are ones that will be
negatively impacted by the predictable collapse in implied volatility.
An example
of a poor trade ahead of earnings would be simply buying long puts or long
calls. This trade construction will face a strong price headwind as implied
volatility returns toward its normal range after release of the earnings.
Let us
look at simple examples of a bullish trade, a bearish trade, and a trade that
reflects a different approach. The core logic in constructing these trades is
that they must be at the least minimally impacted by decreases in implied
volatility (in optionspeak, the vega
must be small) and even better they are positively impacted by decreases in
implied volatility (negative vega trades).
The
bullish trade is a call debit spread and the P&L is graphed below: Click
to ENLARGE
Bullish
AAPL Option Strategy
This trade
has maximum defined risk of the cost to establish the trade, a small negative
exposure to decreasing implied volatility, and reaches maximum profitability
at expiration when AAPL is at $615 or higher.
The
bearish trade is a put debit spread and the P&L is shown below: Click to
ENLARGE
Bearish
AAPL Option Strategy
Its
functional characteristics are similar to the call debit and it reaches
maximum profitability at expiration when AAPL is at $595 or lower.
And
finally the different approach, a trade called an Iron Condor, with a broad
range of profitability. The Iron Condor Spread reflects the expectation that
AAPL will move no more than 1.5 times (1.5x) the predicted move: Click
to ENLARGE
Apple
– AAPL Option Iron Condor Spread
This trade
has significantly less potential profit than the directional trades but it
does not require accurate prognostication of the price direction related to
the earnings release. It is profitable as long as AAPL closes between $551
and $651 at expiration. This is an example of a “negative vega” trade which profits from the collapse of
implied volatility.
These are
but three examples of a multitude of potential trades to capture profit
around AAPL’s earnings cycle. These same trade constructions and rules
apply to any underlying ahead of a major earnings release, economic data
release, or FDA announcement where one or a small group of underlying assets
are significantly impacted.
Within
each of these groups, there are multiple potential specific constructions of
strike price combinations that can be optimized to reflect a wide range of
price hypothesis.
In next
week’s column, we will return to this intriguing topic of trading
options around earnings and see how our example trades performed. Until then,
Happy Trading!
JW
Jones
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