With earnings season kicking off in late October, the next few weeks should offer volatility traders a myriad of opportunities to deploy attractive edge.
Whether you prefer long premium positions, short premium positions, or a blend of the two, there's a strong likelihood you’ll identify at least a few opportunities this Fall that are based on changes in implied volatility related to earnings announcements.
As discussed frequently on the tastytrade network, one of the most prevalent ways to trade earnings is through short volatility positions which take advantage of the rise in implied volatility as earnings events get closer on the calendar.
For more information on the core principles of trading earnings, we recommend this previous installment of Options Jive.
When filtering for earnings trades, many market participants rely on a metric such as Implied Volatility Rank (IVR) to gauge whether current levels of implied volatility are "cheap" or "expensive."
However, because of the "event risk" associated with earnings (the possibility of a big move in either direction), traders may want to add another layer of analysis to their methodology when evaluating such trades.
A review of this approach is presented on a recent episode of Market Measures, and we think a quick review of this material is definitely worth a few moments of your time.
The key to this approach is a comparison of past earnings moves versus the expected move for an upcoming earnings event. An analysis such as this starts by looking back at all (or a portion) of a company's historical earnings days, and then calculating an “average move” for the instances in question.
Taking hypothetical Company ABC as an example, imagine that on its last two earnings announcements (the trading day immediately following the announcement), the stock moved 5% and 10%, respectively. Taking an average of those two data points gives us a benchmark for comparison of 7.5% (10% + 5% = 15%, 15%/2 = 7.5%).
When a new earnings season approaches (there’s one each quarter), a trader can then identify the particular expiration month that will capture the upcoming earnings announcement. Once that expiration month is listed, he/she can calculate the “expected move” for ABC stock implied by the options market.
For example, imagine that Company ABC is set to report earnings in 15 days and that the front-month straddle (which captures the event) is priced at $1.50. If we assume that ABC's stock is trading for $21/share, then the expected move for this earnings event is $1.50/$21, or 7.14%.
Based on our previous analysis of the two most recent earnings events in ABC, we can now compare the “past moves” for ABC with the “expected move” for the upcoming event. In this particular example, a trader might conclude that the options are "fairly" priced for the upcoming event, because the options are implying a percent move that is on par with historical movement in ABC (7.14% vs. 7.50%).
Now imagine the straddle was priced at $0.50 or $5.00? Those straddle prices imply a move of 2% and 23%, respectively.
In the 2% case, a trader might consider buying premium for earnings, with the hope that the underlying would make a move closer to its historical average of 7.5%. In this case, it’s highly unlikely a trader would consider selling an earnings straddle for $0.50.
On the other hand, if the options were implying a move of 23%, a trader might indeed consider deploying a short premium trade in ABC. Obviously, the “past move vs. expected move” represents only one component of the trade evaluation process, and a trader would still need to ensure that the potential trade meets his/her standards in every regard, prior to trade deployment.
If you are looking to learn more about this topic, the aforementioned episode of Market Measures provides an in-depth discussion on “past moves vs. expected moves” as well as providing several “real-life” examples.
As you can see in the slide below, implied volatility in MSFT was predicting a move of about 3.5% for the most recent earnings in July, while historical datas showed the stock had moved about 5% (on average):
Depending on your own unique outlook, risk profile, and strategic approach, it's possible you might have found the MSFT earnings trade attractive based on the expected move vs. past moves data. At the very least, if you were considering deploying a short premium trade in MSFT for earnings, you may decided against it based on the above information.
We hope you'll take the time to review the complete episode of Market Measures focusing on earnings (past moves vs. expected moves) when your schedule allows
If you have any questions about this material, or any other trading-related topic, we hope you'll leave us a message in the space below, or send an email to firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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