What You Need to Know Before You Make an Earnings Season Trade

by Options Sensei |

Earnings season kicked off

It’s that time of year again; earnings season.  Things kicked off this week with the big banks such as “JPM Morgan (JPM – Get Rating)”, “Bank America (BAC)” and “Goldman Sachs (GS).

Next week tech will start taking center stage with “Netflix (NFLX)” and “IBM (IBM)” two of the notable names reporting.

After a few months of being waffled and swayed by trade talk, geo-political events and Central Bank interventions it will be nice to hear directly from the corporate leaders how their companies are doing and what their expectations are for 2020.

Earnings can be very tricky to trade

Earnings can be very tricky to trade as there are many moving and unknown parts; will the company miss or beat expectations, what will be the guidance, will traders ‘sell the news’ in profit-taking and will the recent overall market volatility override the results.

The banks I mentioned all beat estimates by a healthy amount, yet the stocks are all a bit lower than prior to the reports. Given they had all run-up in the weeks heading into the event this seems to an example of sell the news.

It highlights that even I told you the numbers beforehand you still not be able to profit. But there is one predictable pricing behavior that savvy options trader use to produce steady profits.

The biggest mistake novices make is purchasing puts or calls outright as a means of directional “bet.”   They are usually disappointed with the results as even if the stock moves in the predicted direction the value of the option can actually decline and result in a loss despite being “right.”

Don’t Get Post Earnings Premium Crushed

The problem is that they failed to account for the Post Earnings Premium Crush (PEPC), which is my label for how the implied volatility contracts sharply, immediately following the report no matter what the stock does.

You can see the repeating pattern of implied volatility of Netflix’s options spiking and retreating on the quarterly reports.

volatility stock chart 2020

Source: iVolatlity.com

You’ll often hear traders cite what percentage move options are “pricing in” on the earnings.  The quick back-of-the-envelope calculation for gauging the magnitude of the expected move is to add up the at-the-money straddle.

This article does a great job of explaining how to use the straddle to both assess expectations and potentially profit.

Once option traders are armed with this bit of knowledge, they to advance to use spreads to mitigate the impact of PEPC when looking to make a directional bet.  Some will graduate to getting this predictable pricing behavior in their favor by selling premium via strangles or the more sensible limited risk iron condors.  But these strategies still carry the risk of trying to predict if not the direction, than the magnitude of the move.

Here’s a list of … Continue reading at StockNews.com

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