Earnings season has officially started, and we’re going to see things really heat up next week.
Last week I talked to you about how I don’t typically hold trades through earnings.
First, I don’t like paying the “pre-earnings premium” only to watch all the volatility get sucked out right after the earnings call …
Second, I don’t like trades where I’m essentially “crossing my fingers” that it’s going to go as planned.
I like trades where:
- I can get a good deal (which you already know if you attended our “Triple Threat” mentorship event on Thursday, where we talked about how we actually get the market to pay for our trades … and we gave out not one, not two, but FIVE trade ideas to everyone in attendance … you can watch it here.)
- I have a little more certainty about how things are going to work out. So even though I pretty much never plan to hold trades through earnings, having an idea of where a stock could be headed after the fact can give me a head start on planning my after-earnings moves …
After earnings, sometimes it feels like anything can happen.
It’s not uncommon to see a company beat expectations … and then watch the shares tumble on the charts.
And when you trade options, even if your trade is spot-on … you can still end up with a loss if you get sucked up in a volatility crush, where all that expensive implied volatility (IV) evaporates away …
But there is a little trick you can use to help you figure out at least one aspect of earnings: the post-earnings price move.
You just need to look at option pricing!
Specifically, pricing for at-the-money (ATM) straddle trades.
A straddle trade involves trading both a call and a put on the same underlying, at the same strike price, and with the same expiration date.
For the sake of this discussion, when I’m discussing a straddle trade, I’m referring to a long straddle – which is purchasing both a call and a put. When opening a long straddle, in essence, I am betting that the stock is going to move in one direction or the other.
(On the flip side, you can also open a short straddle, where you sell both a call and a put, which is essentially betting that the underlying is not going to make a significant move.)
Of course, options aren’t free, and you need to take the premium paid into account when trading a straddle.
For example, if a stock is trading at $50, and you purchase an ATM call for $1, and an ATM put for $1, you need the stock to move $2 in either direction for your trade to become profitable – so in this case, you’d be looking for a move below $48 or above $52.
This is precisely what can help us determine the post-earnings move currently being priced in by the market!
To see how much of a post-earnings move is currently being expected, you want to take a look at the cost of an at-the-money straddle for the nearest expiration after earnings (that can be weekly expiration, or standard monthly expiration). So if a company reports earnings on Wednesday, you’ll want to look at options that expire two days later on Friday.
You should also know that this “trick” gets more accurate the closer the earnings report is. If you’re checking a month ahead of the earnings call, you’ll likely get a different result than if you’re checking the day before.
Going back to our example above, the $2 cost of the straddle indicates that there is a post-earnings move of 4% being priced in ($2 trade cost/$50 strike) and the shares are expected to trade between $48 and $52.
Of course, like most things in trading, this isn’t any kind of exact science, just a trick to help you estimate what kind of move the market makers are pricing in. It may also be useful to compare the expected move indicated by the straddle pricing to previous post-earnings moves as a way of helping to put the current volatility expectations into perspective with the historical post-earnings volatility.
Let’s take a look at a real-life example.
Twitter (Ticker: TWTR) reports earnings next Thursday, July 22, after the close. The shares are currently trading at $66.64, so we’ll look at the 66.50-strike straddle, as it is technically the closest to being exactly at-the-money.
We see that the ask for TWTR July 23 66.50-strike call is $3.75, and the puts are currently asked at $3.60. This would bring the price of the straddle to $7.35.
From this, we can estimate that the market expects TWTR to trade between $59.15 and $73.85 in the session after earnings, which is approximately an 11% move. This is actually a smaller-than-usual post-earnings move for TWTR, which has seen an average move of 13.3%.
Does this mean that the ATM straddle is underpriced? I’d argue against trading on this assumption, as TWTR’s post-earnings moves have varied in size from as little as a 4.1% move, to as large as a 21.1% swing over the last eight quarters.
So again, I urge you to use caution when trading earnings. There’s definitely some big profits out there ripe for the taking, but you need to be smart about how much risk you’re taking on.
Your Only Option,