Using options to trade an earnings event can be a great way for a trader to gain exposure while defining their risk. For most stocks, an earnings event can be among the most volatile days it sees during the trading year.
Abercrombie & Fitch Co (ANF). is set to report earnings on June 1, 2018. Now, on average day, Abercrombie will trade in a 90 cent range. However, if you look at the at-the-money straddle (24.50 strikes) you’ll see the option market is anticipating the stock to trade within a $2.90 range or so. In other words, option market makers are implying that Abercrombie could move within an 12% range.
Implied volatility on those options is about 260%. And if you look above at the IV Index mean you’ll see that it stands 69.72. In other words, options priced across different expiration periods are priced significantly cheaper in volatility terms than the contract that has an earnings event.
Why Volatility Matters During an Earnings Event
Options theory tells that a stock has a 50/50 chance of either going up or down. The option model assumes that returns on an underlying stock will be normally distributed.
Most option pricing models use standard deviation as measure for volatility.
But what does an IV Index Mean of 69.72 tell us?
The option market assumes that Abercrombie will move within a 69.72% standard deviation. Now, if the stock is trading at $24.99, we would multiply .6972 by the price of the stock. That comes out to 17.42.
Now, option volatility (also known as implied volatility) is expressed in annual terms. To express it in daily terms, we would have to take the square root of the number of trading days, which is approximately 15.9.
So we take 17.42 and divide it by 15.9 and we get $1.10. In other words, 69.72% annualized implied volatility converted to daily terms means that we can expect the stock to trade within a $1.10 range 68% of the time.
Most traders understand volatility in daily terms than annualized volatility, especially if they are primarily short-term trading. That said, the higher the implied volatility the more expensive options are priced.
During an earnings event there is a lot of uncertainty, no one is really sure if the stock will go up or down, but they do expect it move much more than it does on average. Knowing what the expected move is can help you when you structure your trades.
That said, after an earnings event is over, implied volatility drops hard, sucking out the premium in the options. That’s why buying outright calls or puts can be risky when your trading an earnings event. You’ll need the stock to make a large enough move to overcome what you’ll be losing in the volatility drop.
Of course, the options market can be wrong at times. For example, some stocks can have outsized moves greater than what the options market anticipated. That’s why it’s important to know what the implied move is, that way you’ll gain a sense of what the market is anticipating.
How To Structure Trades Around An Earnings Event or Volatility
Let’s say you had a bullish bias on Abercrombie going into earnings. If you buy the 24.5 strike calls, they would cost you about $1.40 per contract. In order for you to break even on the trade you would the stock to rise by nearly 6% to be able to cover the cost of the option.
However, there are plenty of ways to play it. For example, if you bought the 24 strike calls they would cost about $1.70. Now these options are more expensive than the 24.50 calls, but they are relatively cheaper.
Well, the 24 strike calls are 49 cents in-the-money. If you subtract $1.70 from $0.49 you come up with $1.21 in premium, slightly cheaper than the 24.50 strikes.
Another way to play the bullish trade is to put on a debit spread. For example you could buy the $24 calls for $1.70 and sell the $27 calls for about $0.50. Altogether the trade would cost you about $1.20 but it would be only be $0.70 in premium. By placing a debit spread you are able to bring down the cost of the trade, as well as reduce the role volatility has on the option.
In order for you to break even on this trade, you would just need Abercrombie to move up to $25.20. If you recall, to break even on the $24.50 calls you would need the stock to go to $25.90.
Now, you can also use the high implied volatility in your favor. For example, you could sell the $24 puts for $1.25, if the stock stays put or rises you’ll make money on the trade. You would start losing money if the stock were to drop below $22.75.
These are just some of the basic strategies that you can use when you have a bullish bias during an earnings event. I may also use these options strategies to trade an earnings event.
The Bottom Line
Option premiums are juiced ahead of an earnings event. The best way to figure out how much volatility to anticipate is to look at the at-the-money straddles. This is done by adding the premiums of the options that closest reflect the stock price. In the Abercrombie example it is the $24.50 strike prices (calls and puts).
Implied volatility is expressed in annual terms, but you can convert it do daily terms by using the formula discussed above. Once you have a gauge on how the option market makers are pricing the event you can then think about ways to put together a trade. You should always calculate your break even points before deciding to place your trades. That way you won’t get caught off guard.
Implied volatility will get crushed after the earnings event, sucking the premium out of the options. For example, check out the IV index mean in Chicos (CHS) after its earnings event:
Buying deep in-the-money options generally have lower implied volatility, but they are still relatively high during an earnings event. One way you can combat that is by trading debit spreads.
This is not just the case for earnings events, it happens whenever there is a period of uncertainty surrounding a stock. Using options to trade an event is a great way to get exposure while limiting your risk. However, be selective with the strategy you chose and be ready for the volatility crush.
Kyle Dennis runs Kyle Dennis’ Biotech Breakouts (biotechbreakouts.com). He is an event-based trader, who prefers low-priced and small-cap biotech stocks. He’s also using his knowledge and looking to multiply his capital through options trades.