Hey Traders,
You may have noticed that during earnings season, I do NOT like to hold onto any of my trades through earnings.
Why is this?
Is it just the unpredictability of stock moves post-earnings?
Actually, no.
The problem is, even if I am right about where a stock is headed after stepping up to the earnings mic …
My trade might still lose.
Here is what you need to watch when trading through earnings.
It’s Just A Little (Vol) Crush
One of the big factors in how cheap or expensive an option is is the implied volatility being priced in.
Implied volatility (IV) is essentially how much future price movement the market is expecting.
When implied volatility is higher, you end up paying more for options, because the market expects a higher likelihood that a stock will make a big move.
Which makes sense. Take a look at how much Amazon (Ticker: AMZN) has moved around its last two earnings reports …
And notice how the 30-day implied volatility (the red line on the bottom chart) tends to spike into earnings, and fall after earnings.
So when you’re buying options ahead of earnings, you’re usually paying for higher-than-normal implied volatility …
But then beware of what happens immediately after earnings …
A lot of that IV is sucked right back out.
This is because the higher IV represents an “uncertainty premium” – but after the shares have taken their turn at the earnings confessional, this “uncertainty” is gone.
We’ve already heard the earnings results, and now those results are then priced directly into the shares.
And this often results in what is called a volatility crush …
Where implied volatility plummets …
And so does the price of your options!
In fact, sometimes volatility crush can be so devastating, it can take a winning option and suck out so much value, you actually lose money!
Let’s look at an example …
Take a look at the Ford (Ticker: F) May 14-strike puts on April 27, the trading session ahead of F’s earnings announcement:
You could pick these puts up for about $0.50, with F closing at $14.85 on the day.
In the session following its earnings report, F actually fell 1.6% to close at $14.62 …
But F’s implied volatility also fell …
And the price of those same options was actually lower throughout much of the next trading session – as low as $0.39!
So even though the option still has plenty of time …
And you were right about the direction of F’s movement …
The value of your options ended up lower!
This is the danger of volatility crush …
And why I avoid holding any trade through earnings, if I can help it.
Of course, earnings aren’t the only time your trades can be affected by a volatility crush …
Check out Twitter’s (Ticker: TWTR) recent IV:
Was it earnings that caused the dramatic rise and fall in IV?
No, it was news that Elon Musk would, in fact, be purchasing the company!
Ahead of the Federal Reserve meeting next week, we can also expect to see some implied volatility – namely, the Cboe Volatility Index (Ticker: VIX), which measures the IV of S&P 500 (Ticker: SPX) options – rise and fall around the event.
If you’re wondering how to trade around it, make sure you join myself and Andrew Giovinazzi this Tuesday at 1:30 p.m. ET for a pre-Fed live session.
See you then.
Your Only Option,
Mark Sebastian