Two Approaches to Trading Earnings

It has become common knowledge that implied volatility for affected options rises sharply as an earnings announcement approaches. The effect is especially strong when earnings are released just one or two days before expiration.

WELL-KNOWN EFFECT
Google represents one of the best examples. Its last four earnings announcements have generated at-the-money volatilities of 140%, 120%, 110% and 120% respectively.

But capitalizing on the rising volatility effect can be difficult when it is partially offset by rapid time decay close to expiration. Some positions will lose money if the stock barely moves, and time decay swamps rising volatility. Both distortions – time decay and rising implied volatility – are strongest at the very end. Investors who structure trades that profit from rising volatility often find that most of their profits accumulate during the final few days.

1. YOU COULD : WAIT UNTIL END
There are two very effective approaches to capitalizing on rising volatility before earnings. The first involves waiting until the very end and purchasing straddles or strangles for just a few hours then closing the trade before earnings are announced.

This strategy is effective for stocks like Google that experience the sharpest part of their volatility increase during the final few hours. Implied volatility for Google options has risen 40% on the last trading day before earnings during each of the last four expirations. An increase this large is guaranteed to offset time decay, especially for options that are purchased after the open on the final day.

OR YOU COULD : USE NEXT MONTH OPTIONS
The second approach involves purchasing trades that benefit from rising volatility using next month options that expire a few weeks after earnings. These options also are affected, but the distortions are much smaller. Because the trade is far-dated, time decay is much smaller, and the volatility increase is more subtle.

For example, next month at-the-money Google options experience an average increase around 50%. On the final day, it is common for near-dated options to trade at 140% and far-dated options to peak out around 35%. Both values represent a substantial increase from the more familiar range in the low 20s where Google options normally trade.

ADVANTAGES
Capitalizing on the more subtle far-dated rise in implied volatility is relatively easy, because it favors positions that normally suffer from time decay and benefit from large moves of the underlying stock.
Straddles and strangles are the most obvious example. These trades are best to own during periods of rising volatility. The earnings effect favors such positions by offsetting time decay with rising volatility. More important, it erases the falling volatility that normally accompanies a rally – a problem that often plagues straddle buyers during a bull market.

Some investors try to capitalize on falling volatility after earnings by selling volatility at the very end just before earnings are released. This approach is one of the most dangerous strategies in the option trading world. Google, for example, has moved much more than the amount priced into its options during three of the past four earnings announcements. In October, straddles doubled from $38 to $76. They likewise climbed from $28 to $48 during the July release and $26 to $49 in April. Very few strategies can lose this much money in such a predictable way.

Finally, some investors trade the falling implied volatility that follows earnings. This game is also difficult, because implied volatility tends to fall more quickly than the rate at which the stock calms down. Although it is counterintuitive, the falling volatility environment that follows an earnings release is often a good straddle buying opportunity.

Written by Jeff Augen