Overcoming The Earnings Dilemma

As a market maker on the CBOE, I always had a simple plan when it came to trading stocks around their earnings announcement: Don’t do it.

I, like most professional traders, didn’t like trading options on stocks with earnings coming out because that was the day of the quarter that typically had the most risk. There’s risk—huge risk—in both the underling stock moving erratically, and also in the option premium potentially being greatly affected by a “crush” of implied volatility. It works like this…

If you buy options, say a straddle, going into earnings to try and make money on the anticipated volatile price action typical on earnings day, the straddle can be very expensive in terms of implied volatility. To be sure, it is common for the implied volatility to get “crushed” when the earnings figures are released. That means that even if your straddle makes money on the underlying stock moving (gamma and delta), it can lose more on implied volatility collapsing (vega) resulting in a net losing trade.

And, of course, selling options has the other side of the risk profile: Yes, you can sell expensive options right before earnings, but if the underlying stock moves too much, you can lose much more on the movement than you’d make on selling expensive options.

And the fact is that the actual stock price action is very unpredictable when it comes to earnings days. So neither (buying or selling) results in a really great trade. Both are craps shoots. … And that is NOT what traders—not good traders, anyway—are in the business of doing.

Rather, clever traders use what they know about option pricing to trade for and advantage. To stack the deck as much as they can in their favor and try and gain an advantage, or edge, and put on a strategic trade.

One way to do this in earnings season is by trading a time spread. These days, that is almost exclusively what I use when I trade earnings. The reason is because under some circumstances, time spreads can give traders that edge they are looking for and traders can structure a sound trade that takes advantage of volatility instead of being at the mercy of it. It works like this…

Typically, options in the expiration cycle that expires just after earnings get very expensive as the collective market buys them going into earnings, driving up implied volatility. But the other months tend to remain relatively stable in terms of IV. So the technique is to buy the “cheaper” (in terms of IV, not absolute price) longer-term options and sell the inflated short-term options. This time spread can be constructed at-the-money for a direction-indifferent bias, above the current stock price for a bullish bias, or below the current stock price for a bearish bias.

For time spreads to profit, the stock must stay in a range, which on the surface seems like the opposite of what a trader wants. But the bigger the disparate differential in IV between the two months, the bigger that range can be and still produce a winning trade. Often a very large range can result. And even if the underlying stock makes a rather large move, it can still land within the profit-making range.

Ultimately, this is a potential way for experienced traders to use certain intricate nuances to take control of volatility and make it work for them instead of the other way around.

For more information, please consider our class next month on time spreads. For more information, please visit: http://markettaker.com/options_education