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Editor’s Note: In your TradeSmith Daily report on Wednesday, April 13, there was an error that incorrectly stated the structure of the pairs trade between INTC and AMD. The text said “…buy one deep-in-the-money put option for INTC…” It should be “…sell one deep-in-the-money call option for INTC…” — TradeSmith Editorial Team
Markets are facing a triple whammy right now with tightening Fed policy, a war in Ukraine, and a COVID-19 resurgence.
So it’s no surprise that FactSet’s Earnings Insight listed earnings growth estimates for the S&P 500’s most recent quarter at 4.5%, the lowest growth rate since Q4 of 2020, which landed at 3.8%.
What you may not know is that for options traders, this creates some incredible profit opportunities.
The difficult part for most folks is knowing where to look among the millions of options contracts out there.
That’s why implied volatility is important.
As one of the three key components of an option’s price, implied volatility follows a repeatable pattern; as a stock approaches earnings, implied volatility increases, and so does the price of that stock’s options.
I want to show you how to exploit this phenomenon.
Earnings = UncertaintyNo other event more consistently causes significant price movement in shares of a company than earnings.
And it’s not hard to understand why.
Earnings provide a comprehensive financial narrative to markets on a quarterly and annual basis, a frequency that is established by law and enforced by the Securities Exchange Commission (SEC) in the U.S.
While Generally Accepted Accounting Principles (GAAP) dictate how financials are reported, companies often provide additional information that includes:
- Corporate presentations
- Press releases
- Non-GAAP financial information
In between earnings releases, investors keep their ears to the ground for news, data, and events that could impact a company’s stock price.
But more often than not, earnings are the main company-specific event that injects volatility into a stock.
This impact is so regular that options markets build earnings into the price of an option.
You may recall from a previous TradeSmith Daily that three components go into the price of an option:
- Time until expiration
- Distance between the option strike price and the stock’s current price
- Implied volatility
As a stock approaches earnings, implied volatility increases for options that expire after the earnings release.
Most people don’t think about this, but one of the main purposes of options contracts is to act as insurance or a hedge against risk, which in this case is unknown price movement caused by earnings news.
Consequently, large funds and investors will buy options contracts to protect their portfolios, leading to increased demand for options.
This directly leads to an increase in implied volatility and the price of a stock’s options.
And guess what happens after earnings are released?
Implied volatility declines, as does the price of the stock options. Once all the earnings information is known by the markets, traders and investors can more accurately value and price the company’s stock.
There’s one other important point you should know.
Implied volatility isn’t directional. If the market is pricing in an implied move of, say, 3%, it could be 3% above or below the stock’s current price.
That makes some sense when you think about it.
We’ve all seen stocks pop and drop as well as move sideways from an earnings release. Implied volatility simply tells us the demand for options, which in turn tells us how much investors expect a stock could move based on how much protection they buy.
Creating an EdgeI’m going to share a secret with you about earnings and implied volatility that can give you a mathematical edge:
Implied volatility statistically overstates historical volatility.
It’s been mathematically proven that traders and investors buy more option insurance than they actually need.
The difference isn’t huge, but it’s enough to create a measurable edge.
Here’s what I mean.
Say Apple Inc. (AAPL) has earnings coming up and the options market prices an implied move of $3.50.
An implied move, also known as the expected move, is a measure of one standard deviation (or a range) where the options market expects the stock’s price at expiration 68% of the time.
To determine the implied move for a stock, you add the price of the at-the-money call and at-the-money put together for the soonest expiration after earnings. That will tell you the expected move.
Historically, the actual movement of Apple’s stock may only be $3.40 or $3.30, hypothetically speaking.
Now, sometimes, Apple may move $7.00 versus an implied move of $3.50. Other times it may move $0.25.
On average, though, over enough earnings releases on enough stocks, you will find that implied volatility overstates historical volatility.
We can use that to develop an edge for ourselves by looking for stocks with implied moves that are significantly higher than the actual historical moves.
Then, we set up options trades such as iron condor credit spreads, short strangles, or short straddles that are directionally neutral.
Any one trade could win or lose. Even a series of winners and losers can and will happen.
But if we place enough similar trades to absorb the variance in the outcomes, we should turn a profit.
Before we wrap up, I want to show you a chart of Apple, along with the implied volatility for the stock’s options.
The top half of the chart above shows the daily price action for Apple’s stock, with earnings releases circled in yellow.
On the bottom half, the blue line draws the implied volatility for the stock. I also highlighted earnings with orange vertical lines.
You can see how the implied volatility drops after every earnings release.
Also note in the top half how the first and fourth earnings releases were followed by significant price movement, while the second and third releases saw very little price movement.
As traders, we can compare the implied price movement from earnings to the historical price movement and see how the two match up. When we find trades where the implied movement is high relative to the historical post-earnings movement, we can look to establish trades like short iron condors to take advantage of this setup.
Knowing what you do now, which stocks would you expect to provide the best opportunities for this type of trade and why?
Email me your thoughts.
While I can’t answer your emails individually, I promise to read every one.