There's a new kid on the tastytrade block, and if you aren't yet aware, we highly recommend catching the latest episode of The Earnings Show!
As you probably already know, successful volatility trading is predicated on movement (or lack thereof) in an underlying security.
Generally speaking, short volatility (short premium) positions perform best when an underlying sits still, while long volatility (long premium) positions perform best when an underlying makes a gap move.
Given the above, volatility traders are highly attuned to announcements/events/news that affect the likelihood of a stock moving or sitting still over a given period of time.
Developments affecting stocks are usually broken into two categories - systematic risk (affecting the entire market) and unsystematic/idiosyncratic risk (affecting only one underlying stock). For example, Amazon (AMZN) stock can weaken during a precipitous drop in the S&P 500, but it can also go lower as a result of stock-specific news.
While there's a myriad of things that might fall into the "idiosyncratic" news bucket, one definitive event that drives unsystematic risk in a stock is a company's earnings.
Released by publicly traded companies four times a year (quarterly), an earnings announcement and accompanying financials (income statement, balance sheet, and statement of cash flows) provide a snapshot of the current health and outlook of the business in question.
Earnings announcements can therefore have a significant and immediate impact on a company's stock price - particularly if there are any surprises included in the report, or if earnings in general are very strong/weak.
Volatility traders use earnings in a variety of ways to effectively deploy their strategy. However, one common method of trading earnings using volatility is to buy or sell an earnings straddle in the month of the earnings release. This strategy is often based on an analysis of past earnings moves in a particular underlying.
For example, imagine that stock XYZ is trading $20 and will release earnings in two days. Looking at the front month straddle in XYZ, you see (hypothetically) that the combined value of the front month call and put in XYZ is equal to $2.
One can consequently infer/estimate that based on current implied volatility, the market is expecting a 10% move in XYZ in the wake of earnings ($2/$20 = 10%).
If a trader buys the $2 earnings straddle, he/she is essentially betting that XYZ will move more than $2 prior to expiration. Likewise, a trader selling the straddle would be betting that XYZ would move less than $2 prior to expiration.
What data might help evaluate the preferred side in this trade?
Imagine that looking back on the last 12 earnings releases (3 years) for XYZ, you see that the stock has never moved more than 10% on the day after an earnings release. Would you be more likely to buy or sell the straddle?
Every trader will make a different assessment of risk based on their unique strategy and approach. Deploying positions for earnings is just one of the many ways that options traders can capitalize on opportunity in the market - assuming it fits their portfolio and risk profile.
The Earnings Show on the tastytrade network, hosted by Tony Vitale, provides a platform for discussing upcoming earnings and analyzes the relative merit of selected trades to help traders refine their approach.
It should be noted that with little time left to expiration, some earnings trades must be thought of as binary events. When a stock revalues after earnings, especially close to expiration, these trades won't have time to "revert to the mean." A trader will either win, lose, or breakeven on the earnings day - game over.
It's for this reason traders need to be especially cognizant of the risks involved when trading these events.
We hope you'll take the time to watch one (or more) of the recently released episodes of "The Earnings Show" when your schedule allows.
If you have any questions on this type of trade, or a particular position, we hope you'll follow up at email@example.com.
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.