One of the more frequent questions I get asked is how I pick out earnings plays. While this is quite a complex question, I can simplify it into two quick bites:
1. I look at the stock
- How much has it been moving?
- How much does it typically move on earnings?
2. I look at the implied volatility (IV) of the options
- How are the implied volatilities moving?
- What is the relationship of the different months to each other?
While these are clearly not all of the questions I ask myself when formulating an opinion, they certainly sum up how to look at a product when developing a trading approach, and will help me answer questions like:
1. Should I do an earnings calendar spread, or double calendar for that matter?
2. Should I do an earnings butterfly spread?
3. Should I consider entering an earnings play at all?
Chevron Earnings Trade
Take Chevron Corp. (CVX), which announces earnings Friday morning. I want to know if I should make a play and, if so, how much.
First I am going to look at the stock:
- It had a nice run-up in March and early April (as many stocks did).
- In the last 10 days, the stock has done little to nothing, even with the big sell-off on Tuesday.
- When earnings come out, CVX typically does not move very much. Since August 2008, the stock has moved over $2, close to open, on earnings only once. It has moved well under a dollar on earnings on several occasions. Even the intra-day ranges have tended to be somewhat small, the greatest being only slightly more than $4.
Next I am going to take a look at the volatilities of the options:
- In the past week, CVX at-the-money implied volatility has increased by 4 points. A novice trader may point out that the CBOE Volatility Index (VIX) also spiked during that time, but be aware the real S&P 500 (SPX) implied volatility is only up about 2 points since the beginning of the week. Based on this, we can conclude there has been an increase in the implied volatility of CVX options.
- Even with the increase in implied volatility, the 80 strike only has about a 21 IV.
- While the implied volatilities in May are high, they are much greater than those of June.
Based on this information, I am going to formulate a plan. First, I am ruling out any kind of play based on movement. The stock has shown no sign that it moves on earnings. At the same time, I have noticed a bid-up in implied volatility. This makes selling premium desirable.
Next, I am going to rule out a calendar spread. For starters, the stock is right in the middle making a single difficulte. To make matters worse, there is almost no term skew to take advantage of.
This also rules out a double calendar, which becomes obvious when constructing the trade. Traders can see the lack of term skew in that there is a huge dip between the 80s and 85s on this double calendar:
Now that I have ruled out term trades, I am going to look at the butterfly spread. Right now, I can set up a butterfly straddling the CVX 80 strike with this risk structure:
In a perfect world, there would be an 82.5 strike to play, however there is only the 80s and the 85s. Based on the IV skew, there is more benefit to playing the 80s than the 85s (they have more premium).
Notice that this trade has odds of breaking even of almost 45%. That is a good start, but the real kicker is the payout. This CVX trade has a cost of $2.05 per butterfly, and it has a payout of $2.95 per butterfly. That means for every $1 I bet, I have the possibility of getting $1.44 back.
This bet has a 44% chance of winning between now and expiration, but receives 59% of the total credit available in the spread. If I wanted to get fair value of the spread, I would want to receive at least 56% of the value of the distance between the wings (the wings are $5; fair value on the spread is about $2.80).
There are many directional speculative bets that have rewards this good; however, they typically have much lower odds of success than 44%. I would call this spread a “spincome trade,” i.e., a speculative income trade (speculative because it makes more money if the underlying falls slightly, income because it does OK if the underlying stays where it is or rallies only slightly).
These trades typically do not have this good of odds of success, so I feel there is some advantage to this earnings play. Any time I am getting these odds, I am willing to consider entering the trade.
Should You Make the Trade?
However, there is the final question: Does this spincome trade even make sense?
Sometimes the best trade is NO trade, but with odds like this, this trade is one I would certainly consider if I have a bearish or neutral bias on CVX. However, it clearly is not a trade that I would be jumping all over if I was on the floor. If I am even the slightest bit bullish on CVX, I am going to take a pass, even with these odds.
It can be so tempting to enter into an earnings play based on odds, but if there is no reason to think it is going to fall, I may take a pass on the trade. In this case, unless the trader is bearish, they really don’t have many options when it comes to trading these options.
Historical data provided by LiveVolPro. Chart and price information provided by TradeMonster.
Related Articles:
- 5 Rules of Engagement for Trading Earnings
- The Easiest Way to Profit From Mispriced Options
- Understanding Margin Requirements for Selling Naked Puts
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