by Tyler Craig | July 11, 2011 2:25 pm
An Earnings Season Primer for Options Trading Investors
With tonight’s report from Alcoa (NYSE: AA) the quarterly earnings season is officially upon us. As a bevy of announcements are unleashed over the coming weeks investors will receive one more piece of evidence regarding the economy’s strength or lack thereof. Rather than delve into mundane fundamental details like revenue and growth expectations, let’s review a few of the price and volatility dynamics surrounding quarterly earnings announcements.
Earnings announcement almost always act as a catalyst. Due to the preponderance of buying and selling occurring in the after-hours market, stocks often experience large gaps into the next trading sessions. Some stocks have a history of staging notable gaps like Research In Motion (NASDAQ: RIMM) and Google (NASDAQ: GOOG). For others like Wal-Mart Stores (NYSE: WMT), the earnings announcement is largely a non-event. A post-earnings gap is all but assured but the direction of the gap remains ever elusive. It is rare to find a trader who can accurately predict which direction a stock is likely to move following the announcement. As such, there is a high degree of uncertainty with holding stocks into these events. Stock owners unwilling to liquidate their position may consider using option strategies like collars to insure themselves against a large loss.
There are also a few interesting volatility dynamics of note which crop up time and time again during earnings season. First, implied volatility is virtually always elevated going into earnings as the option market seeks to adequately price in the magnitude of the earnings gap. Second, implied volatility drops precipitously following earnings as options revert back to pricing in a stock’s normal volatility. This post earnings volatility crush is why most traders lean toward being net-short volatility heading into the announcement.
Sellers Have an Edge, But …
In general, volatility sellers have the edge going into earnings but it’s no free lunch. It is true that the majority of the time short-volatility strategies (e.g. short strangles and condors) will yield a profit while long-volatility plays (e.g. straddles) result in a loss. The fly in the ointment occurs when assessing the average gain versus loss. Take short strangles for instance. Though you’ll probably win roughly two-thirds of the time, the occasional loss can quickly overwhelm your gains. In the long run selling volatility into earnings is likely to be a zero sum game. In the end, trading earnings profitably comes down to proper position sizing, sound risk management, and a dash of good fortune.
At the time of this writing Tyler Craig had no positions on AA.
Follow Tyler Craig on Twitter@TylersTrading.
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