Risky. Riskier. Riskiest. Nope, this isn’t a lesson on adjectives. But those three words describe three ways you might approach one
of the more aggressive trading strategies out
there: trading around corporate earnings.
You might ask: How will a company’s num-
bers line up with expectations? Will they
exceed or fall below those expectations, and
by how much? How will the company frame
future forecasts? A surprise in any of these
areas can trigger a bullish or
bearish price change that’s
bigger than anyone expect-
ed, sending a stock dramati-
cally higher or lower.
Sure, just about any stock
can move up or down 5% if
you give it enough time (like
a year). But an earnings sur-
prise can pack a 5% move into a single day.
In fact, it’s the speed and potential magnitude of a price change that creates risk. So, if
trading around earnings is risky, why do it?
I T’S ALL ABOUT THE VOL
Remember: implied volatility (“implied
vol”) is a theoretical measure of how much
a stock’s price might change in the future.
Higher implied vol typically suggests future
price changes could be large. It can also mean
higher option prices. Thus, higher implied
vol can mean certain trading opportunities
for those willing to take on extra risk.
But what’s been missing in the market
overall for most of the past couple of years?
High implied vol. The CBOE Volatility
Index (VIX), for example, has spent most of
its time below 15 and its average is about 19.
Traders looking to accept the risk of higher
volatility (“vol”) for potential trading opportunities haven’t had the chance. That’s
where the earnings play comes in.
When there’s uncertainty around
company earnings, the implied vol of the
stock’s options tends to be higher before
the announcement, even if the broader
market’s vol is lower. To see this, take a
look at the option chain on the Trade page
of the thinkorswim® trading platform
from TD Ameritrade. On the right-hand
side you’ll see the overall implied vol for
In Figure 1, with an earnings announcement just four days away, the implied vol of
the options that expire in four days is much
higher than the vol of the later expirations.
This suggests there’s more potential risk
in the near term—that is, of possibly larger
stock price changes in the next two days—
versus further out in the future. The tendency for implied vol to fluctuate, plus the
potential for larger price movements, are
what can make earnings trades interesting
in an otherwise dull market. And earnings
come up every three months.
The earnings strategies described here
focus on the options in the expiration closest to the earnings announcement, where
this increased implied vol is reflected. You
can tweak these strategies to match your
specific stock outlook and appetite for risk.
It’s also possible to trade around earnings
announcements in longer-dated options to
give your strategy more time. Which expi-
ration you choose depends on your opinion
of the stock.
Keep in mind that earnings trades come
in two flavors: either you think the stock will
make a big move, as suggested by the high implied vol, or you think the stock won’t move
as much as the high implied vol suggests.
Risky: Long at-the-money vertical when
you think the stock will move big
This is a pure directional bet on what the
stock’s price might do when earnings are
announced. If you think the stock might
rally, you could buy a call vertical. If you
think the stock might drop, you could buy
a put vertical. An at-the-money (ATM)
vertical could be long the strike that’s the
closest in-the-money (ITM) option, and
short the strike that’s the closest
out-of-the-money (OTM) option. For example,
if the stock price is $80, a long ATM call
vertical could be long the 79 call, and short
the 81 call.
The long vertical has defined risk, limited
to the debit you pay for it. So it’s one of the
less risky ways to trade earnings. But which
vertical you buy is important. If you’re
concerned about a change in the implied
vol of the options after the announcement,
you may want a vertical with relatively low
vega. To get that, consider having the long
and short options of the vertical at adjacent
strikes, where the vega of the options could
be roughly the same. In that case, the long
vega from the option you’re buying, and the
short vega from the option you’re selling,
should offset each other. Maybe not completely, but enough to reduce the vega, or
sensitivity to changes in implied vol from
the long vertical.
Buying a vertical with only a few days to
expiration means there’s not much time to
adjust it if the stock goes against you. But
the theoretical value of a long ATM vertical
that’s close to expiration usually changes
quickly when the stock’s price changes, so
we can expect this to make it very responsive. Even if the stock doesn’t move as much
FIGURE 1: Implied vol and earnings. From the Analyze page of thinkorswim, bring up the option chain of a
stock that has an earnings announcement coming up. Options with less time to expiration are likely to have
higher implied vol. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.