Chris Irvin, MarketTraders.com
Four times each year, stock and equity options traders’ ears perk up.
Like clockwork, their gears start to turn and they type away at the keyboard, looking for the earnings season schedule of big-name companies like Google, Apple, Netflix, Tesla… The list goes on. It’s like an appointment for profits.
Each earnings season, the stock market sees a spike in volatility, in profit potential, for traders with a weather eye on the horizon. As stock traders take to the charts, equity options traders do the same, looking to take advantage of stock movements for pennies on the dollar and get a little piece of the pie.
What if you could do the same?
What if each quarter, you set aside a handful of hours to execute a few options trades where you could potentially profit 25-30% overnight?
It happens, and more frequently than you might think. I’ve been trading for more than 15 years and I’ve not only seen it happen through my students’ successes at Market Traders Institute, I’ve watched it happen in my own account too. The beauty of it is that no matter what time of year it is, you could be preparing for earnings season.
This is the precise strategy that I use each and every quarter…
What is the Earnings Season?
Earnings Season: The time around the beginning of each financial quarter when publicly-traded companies release earnings reports for the previous quarter.
Despite what some traders will tell you, as an equity options trader, the actual earnings number is not the issue. I really don’t even care if the company makes money or loses money. What counts is how investors react to the news.
What is the important part? The knee-jerk reaction of investors.
Because investors assign a positive or negative emotion to those numbers, the stock can jump, or dump. These moves can make for great opportunity if you know how to play the move.
I focus on the reaction that the stock’s price has to the earnings number.
That’s what will drive the intrinsic value in my options, and therefore the profitability in the trade. The intrinsic value of an option is the component of the options price that is DIRECTLY affected by the movement of the underlying stock. If the stock goes up $1.00, the intrinsic value goes up $1.00. That is why we need the stock price to move big. In order for a straddle to work, intrinsic value needs to take off.
The other day, Netflix (NFLX) had its earnings announcement. The company made $0.06 per share, but the bigger story to me was that the $100.00 stock moved approximately $17.00 the next day. That is the type of move that we are after. The total cost of the straddle in this situation was on $12.80 per share. Since the underlying stock moved $17.00, the intrinsic value boosted the trade to a profit. Like I said, I don’t care about the $0.06. I care about the $17.00 and what that move will do for my options.
One of the great things about a straddle trade is that I really did not even care if the stock moved up $17.00 or down $17.00. I would profit either way. That is correct – I do not have to choose a direction. It’s just one more way that this strategy takes the stress out of your trades.
The 4-Step Earnings Season Profit Plan
The Straddle Trading Strategy
An options straddle blows some traders’ minds. You don’t pick the stock’s direction. Truly, your only concern is that the stock moves. Period.
Not a bad strategy, right?
Volatility: The amount of market action. Also known as “the spread” in the market’s waves or the price fluctuations a stock experiences.
Typically, if you’re buying a call option, you’re looking for the stock price to go up.
If you buy a put option, you are looking for the stock’s price to move down.
In an options straddle, you buy a call and buy a put simultaneously.
When you place these orders, you just want the stock to react to the earnings announcement. The bigger the reaction the better. Positive or negative does not matter, we just want it to move dramatically.
Options Straddle: When you buy a call option and buy a put option at the same time, you straddle the market price so that no matter which direction the stock moves, you could profit.
Why Trade In Both Directions?
So you might be thinking, if I’m trading in both directions, won’t the trades cancel one another out? Or worse, won’t that mean that the market will inevitably go against me?
Yes and no.
When the market moves big in one direction, one of your options, either the call or the put, will increase in value. The other decreases in value. You will be losing money in that negative trade, but the objective is to have the winning trade outweigh your losing side. This is where you start to see profit. The profit of the winning trade should be much larger than the loss in the losing position. As a matter of fact, your loser may get crushed into oblivion. The good news is that when you buy options, your risk is limited to the cost of the option, and your reward is unlimited. So if your winner increases by more than the cost of the total loser, we have a winning straddle.
How it Works
The key is buying equal numbers of “at the money” calls and puts prior to the announcement. This is why having the announcement release date on your calendar is so critical. When you buy an equal number of at-the-money calls to puts, you are creating a “delta neutral” strategy. At-the-money call options will have deltas of .50, and At-the-money put options will have deltas of -.50. When these deltas are added together, we end up with a delta of “0,” or delta neutral.
Delta: Stemming from the Greek word diaphora, which means “difference.” This number tells you how much you will profit based on a $1.00 move of the stockl e.g., if a trader buys an option with a 0.75 delta, and the underlying stock moves $1.00, the option will increase in value by $0.75.
Delta Neutral: Puts always have a delta from -1 to 0 and calls from 0 to 1, so when you buy a put with a delta of -0.5 put and a call 0.5 delta, your deltas will cancel each other out and you will be left with a delta neutral position.
You are dealing with two deltas in this case.
Let’s say that we get into a straddle trade where the call option has a delta of 0.50 and the put option has a delta of -0.50. The earnings are released and the stock gaps up in the pre-market. This causes the call options to increase in value, and along the way the delta is ratcheting up, 0.50, to 0.55, to 0.60, to 0.65 eventually moving up to 0.85. This means that my call option is now making me $0.85 every time the stock move up $1.00. That is great!
But what about the put positions? The put delta will start moving in the opposite direction; -0.50, to -0.45, to, -0.40, eventually falling to -0.20. The put, being on the losing side of the trade, is actually losing money slower. In this case, at this level, the put option is losing $0.20 for every $1.00 the underlying stock price moves up. Here is the great thing about the current state of our hypothetical trade. We are making $0.80, with our Call option, for every $1.00 move of the underlying stock, while we are losing $0.20 for the same move with the put. The net result is a $0.60 profit. That is why straddles work!
PRO TIP: The Ultimate Stock and Options Course teaches to buy options with deltas between 0.5 and -0.50 for straddle trades during earnings season. (The trade is not a straddle if you use options with deltas other than 0.50 and -0.50.)
When to Straddle the Market
It’s simple really. The straddle strategy allows a trader to take advantage of a known event that has a high probability of causing the stock to move 10% to 15%, regardless of direction. This is why it’s a perfect strategy to master when trading earnings announcements.
The Key to the Straddle
Understand this: a straddle is not an ideal strategy for every stock at earnings. The reason is that not every stock has the potential for the required move it will take to put the trade into a profitable position. For this reason, you will need to do your homework before placing a straddle.
Now, let’s explain the top five ways to judge whether or not a particular trading opportunity is a good pick for an earnings season straddle trade.
5 Steps to Successful Options Straddles
Step 1: Stalk Your Prey
First and foremost, you’ll need potential stock shares that you’ll want to monitor. All of the following steps require that you have particular companies in mind, access to their current share prices and, preferably, have an idea of when their earnings reports will be released for the coming quarter.
Step 2: Look to the Past to Profit in the Future
Now that you have several stocks in mind, you’ll want to look back on the historical data for the stocks in question, be it Apple, Google, Netflix, Tesla,whichever stock you’re looking to profit from.
To do this, you want to look back on the stock charts and identify the four most recent earnings report releases dates. Once you have found them, check out the price fluctuations in that company’s stock price following each announcement.
You’ll want to answer three questions:
- What was the closing price prior to the announcement’s release?
- What was the opening price the day after the announcement’s release?
- What was the peak or valley before turn price – after the announcement’s release?
Peak or Valley Before Turn Price: The price the stock hits, before its first reversal, after the report’s release.
The measurements from close to open, and close to peak/valley can give you an indication as to whether the stock has moved substantially in the past at earnings announcements. If the cost of the straddle is less than the historical movement at earnings releases, you may have a potential straddle candidate.
Let’s take a look at an older example of this for the sake of clarity.
Below are four consecutive earnings report numbers for Netflix (remember that you’ll always want to pull the four MOST RECENT earnings numbers for judging your potential straddle trade):
Earnings Report from 1/20/15
Pre Earnings Close – $349.40
Post Earnings Open – $414.68 ($65.28 move or 18%)
Post Earnings Peak – $457.38 ($108.28 move or 30%)
Earnings Report from 10/15/14
Pre Earnings Close – $448.59
Post Earnings Open – $332.73 ($115.86 move or 25%)
Post Earnings Low – $331.00 ($117.59 move or 26.2%) – immediate bounce
Earnings Report from 7/21/14
Pre Earnings Close – $452.00
Post Earnings Open – $442.98 ($9.02 move or 1.9%)
Post Earnings Low – $412.51 ($39.48 move or 8.7%)
Earnings Report from 4/21/14
Pre Earnings Close – $348.49
Post Earnings Open – $376.63 ($28.14 move or 8%)
Post Earnings Peak – $380.88 ($32.39 move or 9.2%) – immediate drop
In these examples, you can see that the two most recent earnings releases caused the stock’s price to move between 18% and 30%. If we were looking at a straddle that hypothetically cost 15% of the current cost of the stock’s price, the trade would have potential.
What’s the Magic Number?
Unfortunately, there is no magic number and there’s no holy grail. In the past, I have looked for stock price fluctuations between 12-15% minimum. That often creates enough movement to produce a profitable trade in a straddle situation. The only way to truly make a sound judgement is to determine the current price of the straddle and compare that price against the average price movement over the past four earnings releases. If the cost of the straddle is greater than the average move, the trade probably will not work. If the average move is greater than the cost of the straddle, the trade has a good chance of working.
Step 3: Let the Big Dogs Weigh In
Now, this is a dangerous one if you’re not careful. While we want to consider what key analysts are projecting, we don’t want to trade the news, we want to trade the moves. At the same time, once you have your stock picked out in Step 1, it’s good to check in on the analysts’ insights.
You want to focus in on the highest analyst price target. When the cost of the straddle is added to the current value of the stock, you arrive at a number that is less than the analyst target, indicating that your straddle has the potential of working out.
PRO TIP: Don’t pay attention to the earnings estimates. Instead, look to see where the analysts have set their highest price targets for the stock. This is what they think that the stock is worth. Traders like to drive prices up to the analyst targets and stop, so if the straddle profit target is lower than the analyst price target, the straddle should be in good shape.
Step 4: Don’t Forget the Fibs
The Fibonacci sequence is an old mathematical golden ratio you probably learned in some middle school or high school math class and quickly forgot about it, dismissing it as something you couldn’t possibly, ever in a trillion years use… That is, until you began to trade the markets.
The next step (the decision-making process) for your trade is to draw out the Fibonaccis.
In this instance, you want another point of confirmation. You’re looking to be able to say that the stock has the potential to make the range of movement you’re after within the current extension or retracement. If it is not, then your technicals do not match up with what you require to be profitable in your trade. While this may not be a 100%, sure-fire way to decide whether or not to avoid the trade, it is a critical component many traders take into consideration in passing up a trade.
See what the Fibs look like on the charts:
Step 5: Give the Volatility Charts a Vote
Have you ever seen a volatility chart? These charts help options traders determine whether an option is overpriced or underpriced. This is a wonderful gauge for seeing if the options are priced at a level that is just too expensive to place the straddle.
The chart is very visual, and simple to read. The chart will have two lines. One shows the historic volatility and the other represents the implied volatility. If the implied volatility line is higher than the historic volatility line, the options are thought to be expensive. If, on the other hand, historic volatility is higher than implied volatility, the options are thought to be inexpensive.
What we really want to see is just how expensive our options are. What you’re looking for is the skew between the historic and implied volatility. The closer these two numbers are together, the smaller the skew. The smaller the skew, the less expensive the options and the better your chances will be of covering the cost of the straddle. The wider the skew, the more expensive the trade becomes and your chances of covering the straddle cost goes down.
Skew: A fancy math term for the difference or distance between two numbers.
Historic Volatility: Gauge of how much the stock’s price has flopped around and moved based upon past data.
Implied Volatility: Representation of the average analyst sentiment as to what they believed the volatility will be in the future. (This directly ties into Step 2!)
Earnings season trading is as close to appointment-style trading as you can get. With just one strategy, the options straddle strategy, you could have a payday scheduled for every quarter.
Do you want to get more hands on experience with this strategy?