As Director of Education at Option Pit, one of the most frequent questions I get is how to determine a good earnings play.

This is not an easy question to answer at any level. In fact, I am not sure there is a correct answer, unless the trader knows something the public doesn’t (and that NEVER happens).

While there isn’t a correct answer, there are ways to set up a trade to be in a more favorable position. “Favorable” is the operative word, as there is no best or great position, but there is a way to set up a trade to give you the best odds.

When I am setting up a trade, or teaching my students, I follow a checklist of things to examine in order to find the favorable trade. Here are a few of the things on my check list:

1. Where is implied volatility trading?

Is implied volatility (IV) high or low relative to an earnings month? Additionally, and most importantly, what kind of move is front-month implied volatility implying?

For example, earlier in the month, I was examining Amazon.com, Inc. (NASDAQ: AMZN). AMZN is a popular stock to sell credit spreads and condors into because of the premium it gets into its earnings. However, in this particular cycle, IV was not overly high. I took a quick look at the at-the-money (ATM) straddle and thought this might not be a bad buy. At the time, the straddle was a little under $7. Little did I know the stock would drop 15 points overnight, and then rally back to barely down the next day. This doesn’t mean traders should only buy premium — that’s not true at all — but if the straddle price is low, maybe the condor is not the best play.

2. Where is the relationship between the months?

Is the spread of IV between the earnings month and the following month high or low? If it’s high, then a diagonal spread or calendar spread may be an excellent play. If not, then using all front-month options might make sense.

A trader I was working with saw that Goldman Sachs Group, Inc. (NYSE: GS) front-month IV was really high, and he did not think the stock was going to move for a variety of reasons (he was right). He looked at the back month, saw that it was much lower and decided that a double diagonal spread might make some sense. The trade made about 13% overnight. Not a bad win. The reason he did so well was because he saw that spreading between the months, and put the trade in a far more favorable position than a simple condor.

It is important to remember to make sure that the back month is not TOO high relative to historical IV. To trade multi-month spreads takes a much stronger understanding of IV than a simple condor, so make sure you do your reading before entering in this spread.

3. Look at the paper, follow the paper. 

When I am working with traders at Option Pit, one of the most important things I can stress is to follow the paper. If the paper is saying the underlying is, or is not going to move, the paper is probably right.

Looking back at AMZN, what if there had been a tip that the stock was going to move? There was, when I was reviewing the order flow that day, there seemed to, at least to me, a lot more buying of premium than selling of premium.

Looking closer, most of the large orders were buyers of premium rather than sellers. If I am an AMZN earnings premium seller, and I see that IV is low, and then to top that off the majority of professional paper on the earnings day is buying premium, I would likely choose to sit this one out. Heck, maybe I’d go crazy an even buy a straddle.

What I just wrote out are just a few of the things I look at when trading. While there are certainly other things I examine to pick a more favorable trade, using these three steps will certainly save the average retail trader from some gruesome mistakes.

Yes, some of my checklist is ingrained from years of trading, but by sharing these steps here, I hope to produce a teachable moment. The bad news: I will certainly fail here for some people. The good news: Those that do not have a teachable moment will eventually get one from a trade.

Follow Mark Sebastian on Twitter @option911.

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