Welcome to another earnings season! The internet is full of “experts” who claim they can teach you how to trade earnings and/or have special indicators that signal winning earnings trades. These approaches usually take one of several common but not consistently successful strategies. First is an outright bet on direction – the stock is forecasted to rise on earnings so buy calls. The second is a bet on the assumed volatility crush – volatility will significantly drop after earnings so sell premium. The third is a bet that the stock will move a lot in one direction or the other – so buy a straddle or a strangle. These approaches seem like a 50/50 bet at best and require you to hold through earnings – in other words, no edge. We prefer a strategy that uses objective data to move the odds in our favor.
Using Objective Data For An Edge In The Earnings Trade Setup
Our approach focuses on finding situations where the historical average daily move after a stock’s earnings announcement is greater than the current implied/expected move for the option expiration closest to, but after earnings.
Take a look at FSLY – the implied/expected move based on the current stock price and the current implied volatility is around 15% (the red circle). The average maximum one day move after the last four earnings announcements is almost 19% (the black circle). So the stock moves around 19% after earnings but the market is only pricing in a 15% move….seems like a good trade opportunity…..and a good chance to outperform the current implied volatility…..giving us an edge!
Why does this give us an edge? Think about it. Let’s say we buy a November 5th at the money straddle and earnings are scheduled for November 3rd. The move after earnings averages 19% and we’re paying for only a 15% move. So if the move after earnings has averaged 19%, we are essentially holding the straddle for free up until earnings! This opens up a whole set of other strategies (like scalping gamma) to make money between now and earnings and in fact, oftentimes, the stock move between entering the trade and earnings is enough to generate significant profits without holding through earnings.
Looking For Confirming Data Before Entering The Trade
Once we’ve found a trade like FSLY, what other information can we analyze to be even more confident in this setup? One of the most important tools that we use is unusual options activity identified by The Wall Street Wiretapper. When we look at the Wiretapper, we see that unusual options activity has recently started to pick up confirming our thesis for the trade: actual volatility around earnings will outperform the expected volatility priced into the options.
Additional confirming information comes from the recent multiple sell signals on the High Value Target Tool – another indication the stock is ready to move. The High Value Target tool is another ‘tool’ we use at Masters in Trading to get a feel for a stock's strength/weakness relative to a 21 day moving average of historical volatility. This is a great metric to value how extended a stock is from historical volatility levels.
Entering The Earnings Trade
Now that we’ve found and confirmed the trade, what kind of trade are we looking for? Earnings are expected on November 3rd after the close so we will use the closest expiration after the announcement which is November 5th. The actual trade depends on your risk/return preferences and the amount of capital you’re willing to risk but we are usually looking for straddles and/or strangles. Start by pricing out-of-the-money strangles with 30 to 40 delta calls and puts. Make sure you have a trade plan in place so as the stock moves, you know exactly what actions you’ll take. Actions like – when will you start managing the position, and how will you manage the position. Will you turn one side of the straddle into a vertical call or put position, or will you ‘scalp gamma’ – which is a way of managing your option position using the underlying stock.
Take the Time to Learn How to Trade Options into Earnings
Take your time learning how to trade options into earnings. Learning while trading can get expensive, fast. Learn by paper trading, taking fictitious positions written down in your notes so you’re not learning with real capital and potential real losses.
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