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Apr 11, 2016

Earnings: To Trade or Not to Trade

By:Josh Fabian

Earnings season for Q1 2016 begins today, when Alcoa (AA) announces. Why Alcoa? We have no idea, but when AA announces, that is when earnings season is said to begin. Each quarter, we receive a number of questions about earnings, especially when earnings season starts. In this piece, we’ll discuss under what circumstances we trade earnings, as well as the mechanics for trading earnings.

When are Earnings Announced?

Corporate earnings are almost always announced either after markets close for the day or just before markets reopen. It is rare that earnings are announced during the trading day.

Under What Circumstances Does One Trade Earnings?

Earnings trades are a great way to generate market engagement. At tastytrade, we tend to trade earnings when market volatility is low and premium selling opportunities are scarce. The uncertainty about what the price of the stock might do when earnings are announced increases the implied volatility before earnings.  

What Option Series Do You Use for Earnings Trades?

We use options that expire just after the earnings announcement, which can include weekly options. They tend to experience the greatest increases and subsequent collapses in volatility. That is key for trading earnings.

How Do You Decide What Direction to Trade?

Whoa, whoa, whoa there, Sparky. Direction? Okay, sometimes we (and by, “we”, I mean, Tom) take a stab at direction, but for the most part, we stay neutral. Trading earnings is not about guessing direction.

Earnings trades are about the volatility crush following the announcement. While we want to know what the expected move is so we can place our trades around it, we are not trying to predict direction. We don’t know whether a stock is going to move up, down or sideways, but we do know premium will come out when volatility collapses.

Are the Mechanics for Trading Earnings the Same as any Other Trade?

We use the same short option strategies to trade earnings that we would in any other trade.

The biggest difference between an earnings trade and our regular trades is the amount of time we are in the trade.

We want to limit market exposure when trading earnings. Typically, volatility will rise as an earnings announcement nears. Getting into a trade too far in advance likely means our trade will go against us as premium gets pumped in. Therefore, we like to enter an earnings trade sometime in the afternoon on the day earnings will be announced.

Josh Fabian has been trading futures and derivatives for more than 25 years.

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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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