How to Fade an Earnings Reaction With Options

Traders should consider a wide range of factors when selecting an options strategy to fade an earnings reaction, such as liquidity, timing, capital requirements, and implied volatility (IV) levels. They must also align their strategies with their risk tolerance and consider the expected duration and size of the reversal.

For example, if a stock spikes immediately after its earnings report, a trader might consider buying a put option if they expect a sharp reversal and have a high risk tolerance. This strategy offers substantial profit potential if the stock falls significantly, but the trader also risks losing their entire premium if the stock doesn't fall far enough. The timing of the reversal also matters. Even if the stock eventually declines as anticipated, time decay can erode the put's value if the move takes longer than expected. Changes in IV matter too. Buying a put when IV is elevated can make it more expensive, and if IV falls after earnings, it can weigh on the put's value.

A trader could instead use a bear put spread, which involves buying a higher-strike put and selling a lower-strike put. While this reduces initial capital requirements and potentially lowers the impact of time decay and changes in IV, there are drawbacks to keep in mind. A bear put spread caps the profit potential of the trade, and the trader could still lose the entire net debit paid if the stock finishes at or above the long put's strike price at expiration. The short put also carries early assignment risk. Still, for a trader who expects a moderate price reversal, this approach may be worth considering. 

But what if a trader believes the initial post-earnings move will reverse only slightly or simply stall out? In that case, a bear call spread may be an appealing choice. By selling a lower-strike call and buying a higher-strike call, a trader collects a net credit at the outset of the trade. If the stock then finishes at or below the short call's strike price at expiration, the trader keeps the entire credit. Credit trades can also benefit from time decay and a decline in IV, depending on strike selection. However, the maximum profit of a bear call spread is limited to the initial credit received, so traders could miss out on potential gains if there's a more significant price reversal. And if the stock continues to rally, the trader's losses could exceed the initial credit. There's also early assignment risk to consider because this strategy involves a short call. 

As these examples show, selecting a strategy to fade an earnings reaction can be complex. The table below lists a few common choices and the trading outlooks they might suit. However, these are just general guidelines. As noted above, traders need to consider various factors when choosing an appropriate strategy.

Predicting whether an initial post-earnings move will reverse isn't an exact science, and there's always risk involved. However, traders can use fundamental and technical analysis to help evaluate the possibility of a reversal.

For example, a stock could surge after a company beats Wall Street's earnings estimates, but a deeper dive into the quarterly report could reveal issues, including margin pressures or declines in company-specific metrics such as monthly active users.

Similarly, a stock could plummet after a company fails to meet analysts' expectations, but the report could reveal that the quarter was weak because of temporary factors, such as one-time settlement costs or severe weather events.

Traders might interpret these facts as evidence that the initial price reaction has gotten ahead of itself.

Technical analysis can also help assess the staying power of an earnings reaction. Traders can watch volume, key support and resistance levels, or overbought and oversold conditions for signs that a move may be losing or gaining momentum. However, these signals are open to interpretation, and none guarantees a reversal.

Below, we'll walk through two examples of how a trader might identify a potential reversal and fade it. Both examples use a Relative Strength Index (RSI) and a 20-period simple moving average (SMA). RSI is a momentum indicator that oscillates between 0 and 100. Readings of 70 or above suggest a security may be overbought, while readings of 30 or below suggest it could be oversold.

An SMA averages a security's price over a set number of periods and is often used to identify potential support or resistance. When it's below the current stock price, it can act as a support level or floor for the stock. When it's above the current stock price, it can act as a resistance level or ceiling for the stock.

In the example below, ZYX Corp.'s stock surged after its quarterly earnings report before giving back those gains the next day. If a trader had bought a put option after the initial rally, they may have been able to profit from the stock's retreat. 

In hindsight, there were two technical signals that might have hinted the rally was losing momentum. The first signal came when the RSI (lower pane below chart) crossed from overbought territory back into neutral territory, potentially signaling momentum was cooling. The second signal came when the stock rallied toward its 20-period SMA (blue line) but failed to break above it, potentially suggesting weakness in the rally.

In this second example, ZYX Corp.'s stock plummeted after its quarterly earnings report before paring some of its losses the next day. If a trader had bought a call option after the initial sell-off, they may have been able to profit from this reversal. 

Once again, in hindsight, two technical signals may have hinted that the sell-off was losing steam.

The first signal came when the RSI (lower pane below chart) crossed from oversold territory back into neutral territory, potentially signaling selling pressure was fading. The second signal came when the stock rose above its 20-period SMA (blue line), potentially suggesting the rebound was gaining momentum.

Fading an earnings reaction means speculating that the market's initial response is wrong. That can be a risky game. Traders should always have a clear thesis supporting their expectation for a reversal. They also need to consider what could invalidate their thesis and be prepared to manage their positions if a stock moves against their expectations.