In this article, we want to teach you how day trading earnings with options works. You’ll learn the best trading strategy that can help you take advantage of the rise in implied volatility, how to calculate the earnings expected move, 5 key trading earnings tips and we’re going to share some multi-leg advanced trading earnings strategies if you want to level up your game.
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It’s not impossible to know which way a stock will move post-earnings report. While the positive or negative outcome of the release is difficult to predict, the stock reaction to earnings can be predicted using the right trading earnings strategies.
Throughout this guide, you’ll learn how to trade earnings options without exposing your money to the earnings event itself and the inherent risk associated with earnings announcements.
If you’re wondering what’s the best way to trade earnings with options then we recommend sticking around as you’ll learn some valuable skills.
Why Trading Earnings with Options is a Profitable Game?
Options follow predictable patterns around earnings releases that can yield big profits. Earning reports are an extremely important component of fundamental analysis.
Traders looking to take advantage of how a stock reacts to earnings can look to the options market for insights into what smart money expects.
Stocks have a unique behavior around the earnings season that everyone can capitalize on.
Additionally, a company's earnings report can cause notable price swings which are good news for options traders.
Volatile stocks are an options trader’s dream.
Secondly, one of the six elements of option pricing, namely the time premium, is unique to options and can’t be found with other instruments.
One of the major reasons time premiums can change sharply is during risk events that have the potential to disrupt the stock price.
Trading earnings is the best example of such risk events.
Trading earnings tip:
The stock time premium starts to gain in value as we approach the earnings report.
Did you know you can identify what the market is expecting from the stock price movement by studying the expected move?
Below, we’ll explain what is the expected move.
How to Find Earnings Expected Move?
In a nutshell, the expected move as the name suggests shows how much the stock price is expected to move based on the earnings report.
You might wonder:
How to calculate the expected move?
The expected move can be calculated by checking over the ATM straddle price in the nearest term expiration cycle that has very little time until expiration but including the company’s earnings announcement date.
The straddle option is a neutral trading strategy that profits no matter which way the stock price goes. To construct a straddle you need to buy at the same time both a put option and a call option using the same expiration dates and strike prices.
To learn more about the straddle options, check out our guide Straddle Option Strategy - Profiting from Big Moves.
Options are expected to increase by a pretty sizeable margin when the volatility increases.
What does this mean?
If the implied volatility of the nearest expiration cycle is higher than other expiration cycles than it tells us options traders are anticipating a big move in the stock price.
Let’s consider the following real-life example:
ABC’s underlying shares are trading at $100 per share.
To find the expected move for ABC stock, we look at the at-the-money straddle just before its earnings releases and in the shortest term expiration cycle that includes the earnings releases.
The at-the-money put and call options are trading at $5.60 respectively $7.20
In this instance, the straddle price is $12.80.
This tells us that the expected move for ABC stock going through the earnings announcement is around $13.00.
This is not a solid proof method that is accurate 100%.
The stock price can easily move double the expected move if there is a surprise announcement or less if earnings miss expectations.
It’s always an interesting experiment to check out and see how much the stock price moves relative to the implied volatility.
Let’s see how to trade earnings with options.
How to Trade Earnings with Options
How to trade earnings season is not gambling as many would think.
We’re going to outline 5 key trading earnings tips to trade stock options during the earnings season.
The most important thing is to study the historical earnings cycles.
The idea is to find stocks that have the tendency to move more than the expected move. Such stocks have a higher chance next time to do the same thing.
As the saying goes:
You’re only as good as the stocks you trade.
So, stock selection is important in finding the highest-earning trades.
In options trading, the best time to initiate earnings trade is near the close of the day before the earnings announcement.
To keep it simple stupid, the best trading times earnings is always the session before the earnings release.
If you’re only trying to take advantage of the drop in volatility as long as the stock price moves within the expected price range, you’re not concerned with the direction of the move.
You have to get outside the expected move.
For example, if a stock is trading at $100 and the expected move is $5, then the expectation is for the stock to trade between $95 and $105. In this regard, you have to sell options either outside the $95 - $105 price range or your breakeven point has to be outside that price range.
Furthermore, it is important to keep the position size small.
There are countless reasons an options trade can go really bad during earnings announcements.
If you’re just getting started day trading earnings you should really start small until you learn the mechanics of the options and then you can move on with bigger position sizes.
The fifth and last thing you need to do to play earnings successfully is day trading earnings.
In other words, you need to get the options trades off early.
If the options trade is a winner don’t hold it until the end of the day.
We’re only trying to take advantage of the implied volatility and not how much the stock price has moved. The thing is that you’ll know fairly quickly if your options trade is going to be a winner or a loser.
We’re going to talk about a technique that some advanced options traders use to find the best-earning trades.
Trading Earnings Strategy
We’re going to share some multi-leg advanced trading earnings strategy that capitalizes on stock prices leading up to earnings announcements.
Under appropriate conditions, these earning trades can offer low downside risk and unexpectedly large upside profit.
We mentioned earlier the straddle strategy to play earnings announcements. But a more advanced version of the straddle is the long strangle options strategy.
The main objective in buying a strangle leading up to an earnings release is for the stock price to have a strong and quick reaction, thus allowing us to cash in a quick profit.
See below how to profit from earnings surprises with the strangle options strategy.
How to Place an Earnings Strangle?
Let’s first get specific about what is a strangle options strategy?
A strangle is a neutral options trading strategy that consists of simultaneously buying an equal number of call options and put options with the same expiration date, but with different strike prices.
If you recall, the straddle has the same strike price for both the calls and puts.
There are two main difference between the straddle and strangle options strategies:
- Strangle has different strike prices, straddle has the same strike prices.
- Strangle uses out-of-the-money (OTM) options, straddle uses at-the-money (ATM) options.
A strangle has the advantage that it offers the ability to save money and time. This is because OTM options are less expensive than ATM options. Options traders with a smaller account might prefer using strangle options.
To learn how to construct a strangle, let’s consider the following example:
Assume the stock is trading at $100 per share.
To construct a long strangle, you would need to buy:
- One 105 calls for $1.40
- One 95 put for $1.50
The maximum loss for this options earnings trade is capped at $2.90 per contract.
On the other hand, the profit potential is unlimited.
If the stock price moves above or below the $95 - $105 price range after the earnings announcement, you’ll make a profit. At the same time, if the earnings report fails to produce a meaningful stock price reaction above or below the breakeven prices of $95 and $105, you’ll only lose the initial premium of $2.90 per the contract that you paid.
The good thing is that if you find stocks that historically have the tendency to have a mild reaction to earnings announcements, you can profit by constructing a short strangle.
The short strangle profits when there is limited volatility.
However, on the downside, the short strangle exposes you to unlimited losses if the stock price continues to move outside your breakeven points.
One of the best plays for earnings is spreads.
Spread Options Strategies for Earnings Season
Spreads are flexible options trading strategies that are designed to profit from a surge in volatility in the underlying stock price.
There are two reasons why spreads are the best options trades for earnings:
- You have a “guaranteed” maximum gain (call put credit spread).
- Your maximum loss is limited.
There are different types of spreads but the easiest one to construct is the call credit spreads and put credit spreads.
If you want to learn more about spreads, check out our guide here: Options Spread Strategies – How to Win in Any Market.
In essence credit spreads are options strategies where you buy and sell options at the same time. The options must be of the same class (Call or Put), same maturity date but with different strike prices.
To learn how to construct put credit spread, let’s consider the following example:
Assume the stock is trading at $100 per share.
To construct a put credit spread, you could look to:
- Sell a 97 put for $3.50.
- Buy a 93 put for $0.90.
The net credit for this spread options earnings play would be $2.60 per contract.
If the underlying stock price remains above the $97 strike price, your maximum gain would be $2.60 per contract. If the stock gets hit with a positive announcement, most likely you’ll cash in the profits. However, if the stock falls below the 93 strike price, you’re maximum loss is limited to $1.4 per contract.
If you’re bearish on the stock ahead of its earnings announcement you can construct a call spread options.
Final Words – Day Trading Earnings
In summary, the earning season for many day traders is the most profitable time of the year. Trading earnings with options comes down to either taking advantage of the potential higher volatility or taking advantage of the price move without being hit by the increased volatility. Make sure you only use the trading earnings strategy that is compatible with your investing goals and trading plan.
Here are the key takeaways from today’s lesson:
- Stocks have a unique pattern around earnings announcements.
- Volatile stocks are the perfect combination for options plays.
- Stock time premium pick up in value as we approach the earnings announcement.
- ATM straddle price can help us determine the earnings expected move.
- Study the historical earnings cycles of the stocks you plan to trade.
- The best time to initiate earnings trade is near the close of the day before the earnings announcement.
- Day trading earnings works best if you want to take advantage of the implied volatility.
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