Best of the Week
Most Popular
1. Gold Final Warning: Here Are the Stunning Implications of Plunging Gold Price - P_Radomski_CFA
2.Fed Balance Sheet QE4EVER - Stock Market Trend Forecast Analysis - Nadeem_Walayat
3.UK House Prices, Immigration, and Population Growth Mega Trend Forecast - Part1 - Nadeem_Walayat
4.Gold and Silver Precious Metals Pot Pourri - Rambus_Chartology
5.The Exponential Stocks Bull Market - Nadeem_Walayat
6.Yield Curve Inversion and the Stock Market 2019 - Nadeem_Walayat
7.America's 30 Blocks of Holes - James_Quinn
8.US Presidential Cycle and Stock Market Trend 2019 - Nadeem_Walayat
9.Dear Stocks Bull Market: Happy 10 Year Anniversary! - Troy_Bombardia
10.Britain's Demographic Time Bomb Has Gone Off! - Nadeem_Walayat
Last 7 days
Stock Market Pause Should Extend - 21st April 19
Why Gold Has Been the Second Best Asset Class for the Last 20 Years - 21st April 19
Could Taxing the Rich Solve Income Inequality? - 21st April 19
Stock Market Euphoria Stunts Gold - 20th April 19
Is Political Partisanship Killing America? - 20th April 19
Trump - They Were All Lying - 20th April 19
The Global Economy Looks Disturbingly Like Japan Before Its “Lost Decade” - 19th April 19
Growing Bird of Paradise Strelitzia Plants, Pruning and Flower Guide Over 4 Years - 19th April 19
S&P 500’s Downward Reversal or Just Profit-Taking Action? - 18th April 19
US Stock Markets Setting Up For Increased Volatility - 18th April 19
Intel Corporation (INTC) Bullish Structure Favors More Upside - 18th April 19
Low New Zealand Inflation Rate Increases Chance of a Rate Cut - 18th April 19
Online Grocery Shopping Will Go Mainstream as Soon as This Year - 17th April 19
America Dancing On The Crumbling Precipice - 17th April 19
Watch The Financial Sector For The Next Stock Market Topping Pattern - 17th April 19
How Central Bank Gold Buying is Undermining the US Dollar - 17th April 19
Income-Generating Business - 17th April 19
INSOMNIA 64 Birmingham NEC Car Parking Info - 17th April 19
Trump May Regret His Fed Takeover Attempt - 16th April 19
Downside Risk in Gold & Gold Stocks - 16th April 19
Stock Market Melt-Up or Roll Over?…A Look At Two Scenarios - 16th April 19
Is the Stock Market Making a Head and Shoulders Topping Pattern? - 16th April 19
Will Powell’s Dovish Turn Support Gold? - 15th April 19
If History Is Any Indication, Stocks Should Rally Until the Fall of 2020 - 15th April 19
Stocks Get Closer to Last Year’s Record High - 15th April 19
Oil Price May Be Setup For A Move Back to $50 - 15th April 19
Stock Market Ready For A Pause! - 15th April 19
Shopping for Bargain Souvenirs in Fethiye Tuesday Market - Turkey Holidays 2019 - 15th April 19
From US-Sino Talks to New Trade Wars, Weakening Global Economic Prospects - 14th April 19
Stock Market Indexes Race For The New All-Time High - 14th April 19
Why Gold Price Will “Just Explode… in the Blink of an Eye” - 14th April 19

Market Oracle FREE Newsletter

Top 10 AI Stocks Investing to Profit from the Machine Intelligence Mega-trend

How to Trade Options Around Corporate Earnings

Companies / Options & Warrants Jan 22, 2013 - 03:20 PM GMT

By: J_W_Jones

Companies

The hallmark of a professional option trader is the ability to use a wide variety of trade structures in order to exploit opportunities to profit from specific situations the market presents. One of the opportunities routinely presented multiple times yearly is the impending release of earnings.

Underlying the logic of earnings trades is the stereotypic pattern of increasing implied volatility of options as earnings approach. This pattern is so reliably present that experienced options traders can recognize the approximate date of an impending earnings release by simply perusing the implied volatility of the various series of upcoming options.


As a real time example of this phenomenon, consider the current option chain of AAPL which will report earnings after the market closes on Wednesday, January 23.

As can clearly be seen, the front weekly options, the first series in time following the impending earnings release, has dramatically elevated implied volatility as compared to the series expiring later.

It is because the release of earnings routinely causes reversion of the elevated implied volatility toward its historic mean value that a number of high probability trades can often be constructed surrounding earnings.

I thought it would be instructive to review a recent earnings trade I made in order to see how this consistently observed collapse of implied volatility works in practical terms.

EBAY was scheduled to report earnings after the market closed on Wednesday, January 16. As the price chart below reflects, EBAY had recently rallied and was trading in the price range circled in red.

At the time of the upcoming earnings release, there were only a few days of life left in the

January options which would expire the following Friday afternoon. The then current implied volatility situation can be seen in the option chain displayed below.

Note the elevated implied volatility in the January options as compared to the February options. The value is around twice that of the February options and clearly demonstrates this routinely observed spike as we also have seen above in the case of AAPL options.

My operating assumption was that EBAY would trade down slightly following earnings. This was wrong. As we will see however, proper trade construction resulted in a nicely profitable trade despite incorrect price prediction.

After considering a number of potential trades, I decided to use a short strangle in an attempt to capture the collapse of implied volatility. As a brief review, remember that a short strangle is a two legged position and consists of both a short out-of-the-money call and short out-of-the-money put.

Because my price hypothesis was that EBAY would sell off a bit, I weighted the strangle to the downside slightly by selling different quantities of puts and calls. The P&L graph of the position I took late Wednesday afternoon is displayed below.

The earnings were a bit better than anticipated and resulted in a modest price increase. I was able to exit the position shortly following the market open on Thursday morning for a profit of 6.45% based on the margin encumbrance required to maintain the position under Regulation T rules.

The results of this trade illustrate two critically important points for the new options trader to

understand clearly. First, my price assumption was wrong but the trade was still profitable. For those used to trading stock this may be almost an unbelievable result since in the world of stock trading there is no margin of error for an incorrect price assumption.

The second point is closely linked to the first. The second assumption in this trade was that

implied volatility would decrease substantially. This did in fact happen, the implied volatility of the 55 strike calls decreased from the 69.9% shown above to a post earnings release of 23%.

It was this volatility collapse in both the puts and calls that resulted in the profitability of the trade. Had I used my same price assumptions and constructed the trade using stock, the trade would have been a loser. We invite you to try our service to see how proper trade construction and position sizing can result in a high probability of success.

Happy Option Trading!

If you are looking for a simple one trade per week trading style then be sure to join www.OptionsTradingSignals.com today with our 14 Day Trial.

 J.W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis. J.W. strives to reach traders that are missing opportunities trading options and commits to writing content which is not only educational, but entertaining as well. Regular readers will develop the knowledge and skills to trade options competently over time. Jones focuses on writing spreads in situations where risk is clearly defined and high potential returns can be realized. 

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.  

 J.W. Jones Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules