Earnings announcements are public announcements that display a company’s earnings, or lack thereof. These usually take place on a quarterly basis. This number is generally quantified as “earnings per share.” It’s important to understand how earnings can affect an underlying, as well as that underlying’s option market.
Generally speaking, as the earnings announcement gets closer, implied volatility tends to increase. People are buying options to either speculate on the announcement, or hedge their stock positions, which results in higher option prices and higher implied volatility. After earnings are announced, the uncertainty of what will happen diminishes, and usually we see a rapid decrease in implied volatility because of it. It’s not uncommon to see the nearest expiration cycle that contains the announcement ramp up in implied volatility as the announcement nears, and diminish shortly after the announcement.
Because of this phenomena, we tend to stick to premium selling strategies when it comes to earnings plays. We can take advantage of the implied volatility crush by selling premium prior to the announcement, and buying it back after the announcement. This is especially true if there is very little movement in the underlying.
When it comes to movement in the underlying based on earnings, it can be especially confusing. There are times where earnings exceed expectations, but the stock price still goes down. There are also times where earnings miss expectations, but the stock price goes up. That is why we stick to trading the implied volatility aspect of earnings - directionally trading earnings can be extremely difficult, while implied volatility usually expands before earnings, and contracts immediately after.
We also like to avoid regular 45 DTE trades if earnings are within that window of time. As stated previously, implied volatility tends to creep up as the earnings announcement gets closer. If we are selling premium, this increase in implied volatility can completely offset our theta decay that we expect to see from the time diminishing from the contract. This can put us in a situation where we have to hold the trade much longer than normal, which is not optimal.
Earnings trades are not for everyone, as they involve high amounts of uncertainty and random movements. With that said, it can be an intriguing way to stay engaged when markets are not giving us opportunities elsewhere.
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