Is that time of the year again and a new earnings cycle starts. And again the questions about how to play earnings with options start to popup in the GammaOptimizer service and other spaces that I frequent. So the purpose of this article is to provide some guidance and to bust some myths associated with earnings and options.
Right out of the gate I’ll let you in a secret: There is no magical way to make money with options when playing earnings, period. If anyone is selling you a bulletproof “system” or a fantastic strategy that works all of the time run really fast and really far and don’t waste your hard-earned money with those charlatans. The cold hard truth is that at the end of the day options are just securities like other things out there (shares, futures) and the only way of making money with them is by taking risks and doing the good ole, buy low, sell high thing. Sorry to burst your bubble.
Of course, stock options are not “just securities”, they do offer incredible features that can be exploited in our favor and enhance the risk-reward of a trade but at the same time they can also imperil our trading and more so during special moments of extreme volatility like earnings cycles. So Caveat Emptor as they say.
I have a good section on Option Pricing theory and the importance of implied volatility in my Master Class online course. But for the sake of brevity, I’ll try to condense the relevant bits to earnings here. The important thing to consider here is that option prices are very sensitive to expectations of future volatility in the underlying stock. The main reason is that options dealers need to hedge their risk, and hedging costs increase with volatility, as well as the number of shares needed to hedge a particular option. Of course, dealers always want to be ahead of the curve and they tend to overprice options to take into account this. Most of the time retail traders don’t notice the overpricing that much, but during earnings, it is hard to miss. I bet that many of you have noticed that options get outrageously expensive just before the earnings announcement and there is a very good reason for that. The reason is that in reality is almost impossible for most option dealers to hedge their risk exposure during the event. You see, US companies have this interesting habit of reporting earnings when the market is closed. There might have been a good historical reason harkening to the days when quotes were broadcasted in ticker-tape machines, but in modern markets, I don’t really see any reason for that tradition to continue, but I digress! The net result of companies choosing to report material, market-moving news during periods of extreme low (or no) liquidity is that stock prices tend to move like crazy, I mean really crazy once some modicum of liquidity becomes available again. Perhaps if earnings were reported during market hours would change all of that, but I digress again!
So, the reality is that options dealers are mostly shout out of any sane hedging opportunities when the stock starts to move like crazy, so they have to use the nuclear option and price stock options like if the world would end that day. And that is why options are so expensive just before the earnings release. The worst feature of the earnings cycle is that once the stock reopens again the overpricing is gone and options drop significantly in price (what is known as the volatility crunch).
So what can we do about that? Well, I’ll post part 2 very soon on how to advantage of the overpricing and volatility crunch. But in the meantime here are a couple of recommendations:
– Don’t play earnings with outright options (single calls, or single puts). You are most likely than not to lose money on it due to the overpricing.
– If you must play a particular direction, try to use very tight vertical spreads to minimize overpricing and the effects of volatility crunch.
– Most of the time is better if we can see how overpriced options are and then try to exploit that to our advantage (wait for part 2) ideally with a direction neutral type of trade (my favorite construction).