The importance of earnings season can’t be overlooked, especially for options traders.
When companies announce their profitability once a quarter, the market is provided with important insights into ongoing operations. The lead-up to such reports typically affects the implied volatility of a given underlying quite dramatically as market participants jockey for position.
Earnings season can also have a big impact on broader financial markets. For example, when a bellwether company such as Apple or Google reports earnings, the interpretation of those results can move an entire segment of the market - or the markets as a whole.
At its core, the strategic approach to trading earnings is relatively simple - traders are look for places in which they feel implied volatility is too rich, or too cheap - in the former case, volatility is sold, and in the latter case, volatility is purchased.
For those that are up to date on the earnings trade, a new installment of Market Measures is undoubtedly worth a few moments of your time. The show features new tastytrade research focused on earnings which may help you fine-tune your approach.
The graphic below, taken from Market Measures, illustrates how implied volatility (particularly in the expiration month which captures the event) tends to crash after the announcement. At tastytrade we often refer to this phenomenon as the “earnings crush:”
The graphic above shows us how implied volatility in AAPL, GOOG, and IBM dropped precipitously after earnings - on average roughly 40%. Market participants that sell volatility for earnings are hoping for this precise scenario, as well as little or no movement in the underlying.
While the earnings crush is well documented, the inquisitive mind may wonder whether the opposite side of the coin may also produce a profit. For instance, does volatility get “too cheap” after the “earnings crush”?
It is this precise question that is investigated in the aforementioned episode of Market Measures.
In order to produce the results necessary for a proper analysis, a tastytrade study was designed that included five different stocks and twelve years of historical data. The study backtested purchasing "low" implied volatility in the five symbols after the “earnings crush,” and included the following additional parameters:
Utilized historical trading data in AMZN, IBM, GOOG, GS, and AAPL
Included 12 years of historical data for each symbol
Backtested purchasing straddles after earnings (45 DTE, held to expiration)
Trade entry was end of day (EOD) after earnings release
The above equated to 256 individual trades
The table below summarizes the historical performance of the long premium approach deployed in each symbol included in the backtest:
As you can see from the exhibit above, not one of the symbols produced a win rate that was above 50%. In four of the five symbols, the average P/L was barely above break-even, or it was deeply negative. While AAPL did produce a positive average P/L, the win rate still wasn’t attractive - logging in at only 46%.
Overall, the data from this study indicates that purchasing premium after earnings hasn’t historically produced attractive returns. Depending on your approach, this may be a signal for traders to be careful during earnings season when filtering for long volatility ideas. When a potential long trade idea does pop up, you may want to check and see if the company’s earnings report has already been released, as that may affect the relative attractiveness of the trade.
For a comprehensive examination of this material we hope you’ll take the time to review the complete episode of Market Measures when your schedule allows. If you are looking to take a deeper dive on earnings, this previous installment of The Ryan & Beef Show is also highly recommended.
We hope you’ll follow up with any associated questions or feedback related to the earnings trade by either leaving a message in the space below or contacting us at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.