Earnings season is just around the corner, but are you ready to take advantage of those giant swings in stock prices?
Many companies had very huge price movements after reporting their financial statements, creating the perfect opportunities for deploying trading strategies like Straddles, Strangles, and Spreads. These popular tools allow investors to profit from volatility during this period. We will look into how one may trade options efficiently during this critical period, increasing your profit opportunity.
Stock forecast
Before entering options trading, the first thing to do is predict the stock’s probable movement. This correct prediction is necessary because it aids you in choosing the right strategy that will enable you to exploit the fluctuation of the stock price after the earnings announcement.
For example, if you think after the earnings report, the stock is going to shoot up, buying call options could be a reasonable strategy. On the other hand, if you predict the stock will decline, purchasing put options would be more appropriate. If you believe the stock won’t change much, some other options strategies can help you profit from minimal price movement.
Forecasting stock price movement during earnings season is a complex process that requires traders to consider several factors.
First, the stock’s past performance can provide insight into how the stock has reacted after previous earnings reports. If the stock has consistently risen after positive earnings results, this could indicate that a similar pattern may occur in the future.
Second, investors should pay attention to expert forecasts, as these can strongly affect the market’s reaction. If the actual earnings results differ from analysts’ expectations, it could lead to major price changes.
Third, market sentiment plays a crucial role in determining the direction of the stock. If the market has a positive sentiment about the industry or company, the stock could continue to rise. Conversely, negative sentiment could cause the stock price to drop sharply.
When all these factors come together, traders can make more accurate predictions and develop the proper options strategy to optimize profits.
Volatility forecast
After forecasting the movement of the stock, the second important factor an investor should consider should be volatility prediction. Volatility is the amplitude of fluctuation of a particular stock; it is significant in options pricing. Volatility consists of Historical volatility (HV) and implied volatility (IV), which are basic concepts any investor needs to learn before making a trading option decision.
Historical volatility refers to the stock’s actual price movement over a certain period, such as the last 30 days. On the other hand, implied volatility represents the market’s expectation of future stock price volatility. Commonly, implied volatility increases as the date of earnings release draws near because of uncertainty and the possibility of significant price movements.
For example, it can be seen from the chart below that implied volatility (IV) tends to spike before an earnings report, often surpassing historical volatility (HV). Once earnings are announced, implied volatility contracts and returns to the historical volatility level. That shows how volatility comes into play with options trading. The closer to an earnings call, the higher the volatility; the costlier options contracts become.
Understanding volatility forecasts helps traders assess their impact on options pricing and adjust their trading strategies appropriately. Through volatility, traders can measure the risk, estimate option costs, and maximize potential profit opportunities in earnings season.
Determine the Current Position
Before entering an options trade during earnings season, you should consider your position, risk tolerance, and profit objectives. Are you going to hedge the risk or speculate on huge price swings? Will you initiate a new position or manage the one currently in position? The answers will determine the appropriate strategy to take.
If you already have a long stock position and are concerned that after the announcement of earnings, the stock might fall, you can:
- Buy a Put Option: When the stock falls, the value of the put option will increase, hence offsetting losses on the stock position. It is a standard method to hedge risk.
- Sell a Call Option: You can sell a call option to collect the option premium if you expect the stock price to reduce slightly or remain stable. This will help you offset the loss of the price drop.
If you don’t own the stock but want to profit from post-earnings price swings, you can:
- Buy a Straddle: Buy a call and a put option if you expect high volatility and are uncertain about how it will go; you can take profit from the upward or downward stock movement.
- Buy a Strangle: If you anticipate strong price movement but want an option that is more cost-effective than a straddle, then buy an out-of-the-money call option and an out-of-the-money put option.
If you think the stock will have a good earnings report and its price will go up significantly, you can:
- Buy a Call Option: This is when, due to the expected movement of the stock price up, the call will dramatically appreciate, providing high returns with lower capital than buying the stock directly.
- Bull Call Spread: You can buy a lower strike price call option and sell another at a higher strike price to collect the premium, thereby taking advantage of the expected upward move with lower costs.
Advanced options strategies for earnings
In this section, we will look at some of the most powerful options strategies used during earnings season. These include Long Straddles, Short Straddles, Long Strangles, and Call & Put Spreads. These strategies help you take advantage of different market conditions, whether you expect big price moves, little movement, or want to hedge your existing positions. Let’s break them down one by one.
Long Straddles
When trading options during earnings season, one effective strategy is the Long Straddle. To use this strategy, investors need to predict the price volatility of the stock. A Long Straddle is a good choice if you expect the stock to have large price movements but you’re not sure whether it will go up or down.
This strategy involves buying one call option, and one put option on the same stock with the same strike price and expiration date.
If the stock rises sharply, the call option will gain value, allowing you to profit from the price increase. On the other hand, if the stock drops sharply, the put option will gain value because you can sell the stock at a higher strike price than the market price, leading to a profit from the price drop. However, if the stock doesn’t move much and stays close to the strike price, both options will expire worthless, resulting in a loss.
Therefore, the Long Straddle strategy works best when you expect big price swings beyond what the market anticipates.
Short Straddles
A short straddle strategy would be used when the investor expects that, after an earnings announcement, the stock would remain steady or move within a small boundary range.
The option strategy entails selling one call option and one put option of the same underlying, with the same expiration date and strike price.
Unlike the long straddle, which realizes profit from substantial stock price movements, profits from the short straddle strategy occur when the stock price stays close to the strike price. The profit is the premium received for selling the options. In theory, unlimited risk would emanate from a significant stock price movement in either direction. Strategy is typically applied in stable or low-volatility markets.
Long Strangles
If an investor expects the stock to move significantly after the earnings report but is unsure about the direction (up or down), the long strangle strategy could be a good choice. Compared to the long straddle, this strategy allows investors to choose different strike prices for the call-and-pull options, which lowers the overall cost.
This strategy involves buying a call option and a put option on the same stock but with different strike prices. This is the main difference between a long strangle and a long straddle. While a long straddle uses the same strike price for both options, a long strangle uses two different strike prices, reducing the initial cost.
For example, if the stock is trading at $100, an investor can buy a call option with a $105 strike price of $2.00 and a put option with a $95 strike price of $2.50. This strategy’s total cost (or maximum loss) is $4.50 per contract. The profit comes from large price movements in the stock. The strategy will generate profit if the stock price moves beyond the breakeven points of $90.50 and $109.50. However, the investor will lose the entire premium paid if the stock price does not move significantly.
The long-strangle strategy suits investors who want to lower their costs when expecting significant price movement without knowing the direction. It is a better option than a long straddle if the investor accepts a higher breakeven point in exchange for a lower upfront cost.
Call and put spread
When one investor expects a stock to have a big move after its earnings report and is unsure in which direction, they generally use spread strategies to maximize the profit and have control over the risk. A spread is an options trading strategy whereby the investor buys and sells different options of different strike prices and/or different expiration dates.
Based on the prediction about the stock price movement, popular strategies include Bear Put Spread, Bear Call Spread, Bull Put Spread, and Bull Call Spread.
Example: A Bear Put Spread
Let’s say an investor expects stock XYZ to drop after the earnings report. They use the Bear Put Spread strategy to make a profit while controlling risk. If the stock is trading at $100, the investor buys a put option with a strike price of $100 (costing $5) and sells a put option with a strike price of $90 (receiving $2). The initial cost is $3.
- If the stock price drops to $85, the put option with the $100 strike price will be worth $15, while the put option with the $90 strike price will be worth $5. After deducting the initial cost, the maximum profit is $7.
- If the stock price does not drop, both options will expire worthless, and the investor loses the maximum amount of $3 (the initial cost).
