In general, the price of an equity eventually reflects the pattern, or projected trend, of the underlying company's earnings. In other words, the stocks of firms with steady earnings growth tend to appreciate over time more than the stocks of companies with inconsistent earnings or losses. Which is why so many investors closely monitor earnings reporting.
Through option trading, one may now speculate on earnings without taking a position. As long as there are grounds to anticipate specific swings in an earnings announcement or if the stock has a history of actively reacting to earnings releases, traders can use a long straddle or strangle to profit from the anticipated price movement.
In this article, we will discuss earnings announcements and how option traders are profiting from them.
Earnings Announcement: All Eyes On
A company's earnings announcement is the public disclosure of its profitability for a specified time frame. Typically, an earnings announcement outlines quarterly or annual profit.
Generally, if a firm has been profitable up to the disclosure, its stock price will climb prior to and somewhat after the announcement. Conversely, if a firm discloses earnings that are significantly lower than expected, this can result in a sharp, unanticipated decline in the stock price, as investors sell their shares to minimize the risk of a further decline.
Because earnings releases can have such an impact on the market, they are frequently used to forecast the opening of the following trading day.
The Securities and Exchange Commission (SEC) requires publicly traded U.S. corporations to report quarterly earnings and sales statistics. Occasionally, though, a firm announces an earnings surprise, and the stock market responds with decisiveness. Occasionally, the reported results are far better than anticipated, resulting in a positive earnings surprise, and the stock responds by increasing strongly in a relatively short amount of time to reflect the firm's new and improved position.
How Are Earnings Announcements Predicted
When assessing future earnings of an organization, estimates are one of the most essential factors to consider – Analysts use forecasts, management reviews, and other essential facts about a firm. They may, for instance, employ the discounted cash flow (DCF) model.
Analysts might also depend on the key elements highlighted in the Management's Discussion and Analysis (MD&A) section of a company's financial statements. This section offers a summary of the company's activities and financial performance for the preceding year or quarter. It explains why specific components of the company's income statement, balance sheet, and cash flow statement increased or decreased. The MD&A includes a discussion of growth factors, hazards, and even ongoing litigation. In this part, management frequently discusses the upcoming year, stressing future objectives and approaches to new initiatives, as well as management changes and/or major recruits.
Finally, analysts may also analyze external components, such as industry trends (e.g., important M&A transactions, bankruptcies, etc.), the macroeconomic environment, upcoming Fed meetings, and prospective interest rate increases.
Using Options to Profit from Earnings Announcements
Whether an earnings announcement causes upward or downward price movement, the long straddle option trading technique can provide a (potentially) successful trading opportunity in either case.
As a reminder, a long straddle entails purchasing a call option and a put option with the same strike price and expiration month. To utilize a long straddle to speculate on an earnings announcement, traders must first know when earnings for a certain stock will be released.
Traders may also examine the stock's past performance to ascertain whether it is generally volatile and whether it has historically responded strongly to earnings releases. The better a stock is, the more volatile it is and the more likely it is to respond aggressively to earnings announcements. The next stage, assuming an eligible stock has been identified, is to build a long straddle prior to the company's next earnings report.
Finding the right timing
Primary concern is when to initiate a transaction. Some may enter a straddle six weeks prior to the earnings announcement in the belief that the price may move in anticipation of the latter, whilst others may wait until a few weeks prior.
In any event, traders should attempt to establish a long straddle at least one week before the earnings announcement. This is because the amount of time premium built into the option price of a company with upcoming results will frequently increase shortly prior to the release, as the market expects the possibility of heightened volatility after earnings are revealed.
In short, options might give a favorable entry opportunity two to six weeks prior to the earnings release.
Weighting the expiration
Next component to consider is the expiration month – the target being to buy adequate time for the stock to move sufficiently to produce a profit from the straddle (without spending too much). As we have seen, the ultimate objective of purchasing a straddle before an earnings announcement is for the stock to respond fast and aggressively to the announcement, allowing the straddle trader to profit immediately.
In general, investors should not hold a straddle position with options that have less than 30 days remaining until expiration, as time decay tends to accelerate in the final month before expiration. Similarly, it makes sense to give the stock at least two or three weeks after the results announcement to move before entering the final 30 days before expiration.
The Bottom Line
The earnings season represents a pivot moment for many investors. And option trading allows investors to profit from earnings announcements without having to take a position – if traders have specific reasons to predict substantial volatility in response to an earnings report, they can utilize options to profit on the expected market change and potentially quickly generate sizeable returns.
Nonetheless, investors should be reminded that implementing an option trading strategy in response to earnings announcements involves risk. Timing the market is an unrealistic behavior. Thus, such a technique may result in losses if anticipated outcomes do not materialize. Furthermore, it is recommended that only savvy, well-informed investors implement such option trading strategies, as they demand precise time positioning and management.