Some option strategies try to take advantage of the increase in implied volatility that often occurs before an earnings announcement.
We review examples of both types of strategies.
While some buy and hold investors find big market swings to be unsettling, active traders often like high volatility because it brings the potential for big increases (or big declines) in stock prices. This type of market environment is often what we see during earnings season—when a large number of publicly traded companies release their quarterly earnings reports.
Earnings season can spell opportunity, and using the right strategy can help you take advantage of it. However, earnings season can just as easily spell disaster if you use the wrong strategy or if your forecast is incorrect. Sometimes what separates experienced traders from novices is not just how they try to profit on earnings season volatility, but also how they attempt to limit risks.
For most traders seeking to profit during earnings season, there are two basic schools of thought:
- Make the most of potentially higher volatility
- Take advantage of a price move without getting hurt by volatility
Let's take a look at both of these strategies.
Understanding changes in implied volatility
In every earnings season, we usually see several stocks that exceed their earnings estimates and experience a big jump in price, and several others that fall short of their estimates and sustain a big price drop.
Predicting which stocks will beat expectations and which ones will miss is tricky. In my experience, I've often seen an increase in implied volatility in many stocks as the earnings release date approaches, followed by a very sharp drop in implied volatility immediately following the release.
Below is a one-year daily price chart of stock XYZ that shows the typical effects of the four quarterly earnings reports. Note the following:
- The implied volatility average calculation (yellow line) began to rise sharply just about one week before each earnings report, and then dropped off even more suddenly after the report was released (marked by red boxes in the chart below).
- The stock price was relatively stable before earnings, but gapped down (-0.82) on the first report (#1 in the chart below), gapped up (+1.72) on the second report (#2 in the chart below), gapped up (+1.08) on the third report (#3 in the chart below), and was down only slightly (-0.20) on the fourth report (#4 in the chart below).
- While the magnitude of the spikes in implied volatility varied somewhat, it was quite predictable in regard to when it began to increase and how quickly it dropped after the report.
- Note that the price scale on the right side of the chart below only applies to the stock price, not the implied volatility level. While actual implied volatility levels will vary from stock to stock, the example below is a typical illustration of the magnitude of volatility changes that often occur around earnings reports.
The effects of quarterly earnings reports on a stock over a one-year period
Source: StreetSmart Edge®.
Implied volatility is usually defined as the theoretical volatility of the underlying stock that is being implied by the quoted prices of that stock's options. In other words, it's the estimated future volatility of a security's price.
Because implied volatility is a non-directional calculation, any strategy that involves long options will typically gain value as volatility increases (before the earnings report)—meaning that puts and calls tend to be affected about equally. For the same reason, long option strategies will typically lose value quickly as volatility decreases (after the earnings report).
As a result, buying calls (or puts) outright to take advantage of an earnings report that you believe will beat (or miss) the earnings estimates is an extremely difficult strategy to execute. This is because the drop in option value due to the decrease in volatility may wipe out most, if not all, of the increasing value related to any price change in the stock. In other words, a substantial price move in the right direction may be needed to end up with only a very small net gain overall.
Strategies that benefit from increases in implied volatility
For stocks whose charts resemble XYZ above, there are strategies that you can use to take advantage of this fairly predictable volatility pattern while largely minimizing the effect of the earnings-related price move.
If purchased about a week before earnings announcements, long calls, long puts and strategies including both, such as long straddles and long strangles, may be sold at a profit just prior to the announcements if they gain value as the implied volatility increases, even if the underlying stock price stays relatively unchanged.
The table below shows how the prices of this stock's options would move – theoretically – as the implied volatility changes around each earnings report. It also illustrates the substantial effect volatility changes can have on option prices.
Effect of volatility changes on stock prices
Source: Schwab Center for Financial Research.
- Column B shows the prices of long at-the-money (ATM) calls and puts and the implied volatility level exactly one week before each of the four earnings reports.
- Column C shows those prices one day before earnings, when the implied volatility reaches its peak. In all four earnings seasons, the price of the calls and the puts increases substantially, even though the stock price is relatively stable.
- Column D shows what the theoretical value of those options would have been after earnings were announced, if there had been no price change in the underlying stock (in order to illustrate the magnitude of the volatility effect).
- Column E shows the actual prices of those options including the effect of the actual price change of the underlying stock.
In this example, if you had bought calls a week before the price gapped up on earnings, you would have been profitable by 0.96 (1.71-0.75) on the second earnings report and by 0.65 (1.15-0.50) on the third earnings report.
If you had purchased puts a week before the price gapped down on earnings, you would have been profitable by 0.33 (0.95-0.62) on the first earnings report, but you would have lost 0.03 (0.44-0.47) on the fourth earnings report.
Note that it's possible to make a profit on long options purchased before an earnings report, as long as you are correct about the direction and you purchase them before the volatility spike occurs.
However, notice that for the second earnings report, if you had bought calls only one day before earnings they would have cost you 1.80 per contract, and although the stock price increased by 1.72 when earnings were announced, those calls would have declined in value to 1.71 as volatility dropped.
Likewise for the third earnings report, when the calls fell from 1.30 just before earnings to 1.15 after earnings.
On the put side you would not have fared any better, as prices dropped from 0.98 to 0.95 after the first earnings report and from 1.00 to 0.44 after the fourth earnings report.
In all four cases, the volatility decline completely wiped out the benefit of the price move on the underlying stock, even when you picked the correct direction.
If you had bought the long straddle (calls and puts) prior to the table's four earnings reports, you would have been profitable by 0.20 (1.75-1.55) on the second earnings report and only 0.02 (1.21-1.19) on the third earnings report. As the numbers show, you would have sustained small losses after the first and fourth earnings reports, of -0.21 and -0.25, respectively.
Again, these results were due to the large volatility drop canceling out most or all of the effect of the stock price move.
While this is just one example, the best performing strategy was purchasing calls, puts, or both (long straddle) about one week before earnings, and then closing out those positions about one day before earnings, as the spike in volatility caused all of the options to gain value, despite the relative stability of the stock price.
More importantly, because the positions were closed out before the earnings reports, picking the direction of the stock after the earnings reports, was not a relevant factor. (Keep in mind, if there had been a sharp price move in either direction during the week before the earnings report, it could have wiped out any benefit from the volatility increase).
Strategies that benefit from decreases in implied volatility
As discussed, long options tend to gain value as volatility increases, and tend to lose value as volatility decreases. Therefore, long calls, long puts, and long straddles will generally benefit from the increase in implied volatility that usually occurs just before an earnings report.
In contrast, short (naked) calls, short (naked or cash secured) puts, short straddles and strangles, if sold just before earnings, can sometimes be bought back at a profit just after earnings, if they lose enough value as the implied volatility decreases, regardless of whether the underlying stock price changes or not.
The key to profiting from these strategies is for the stock to remain relatively stable or at least stable enough so that the stock price change doesn't completely cancel out the benefit of the decrease in volatility.
One way to estimate how much a stock price might change when earnings are announced is to forecast the (implied) move mathematically.
As previously mentioned, implied volatility is the estimated volatility of a stock's price that is being implied by the options on that stock. As stock prices are usually forecasted using a normal distribution (or bell) curve, an option with an implied volatility of 30% is implying that the underlying stock will trade within a price range 30% higher to 30% lower about 68% of the time (one standard deviation) over a period of one year.
The formula for this calculation is:
(Stock price) x (IV) x square root of time in years
From this, you can determine how much the stock is expected to move during the life of an option contract. Manipulating the formula somewhat yields the following:
(Stock price) x (IV) x square root of # days until the option expires
Square root of # days in a year
Because option prices tend to get more expensive as an earnings announcement approaches, a slight calculation variation can be used to forecast how much the stock is expected to move when the earnings come out. This formula is often called the "implied move." For a stock due to announce earnings right after market close, the formula would be:
(Stock price) x (Implied volatility)
Square root of # days in a year
Referring to the above table, because XYZ was trading at approximately $17.75 per share prior to the first earnings report and the implied volatility of the front month ATM options was 72% just before earnings, the calculation below implies a 0.67 move in either direction. In other words, there is about a 68% chance that XYZ will increase in price up to $18.42 or drop in price down to $17.08 when the earnings are announced.
Earnings report one:
17.75 x .72
19.104 = .67
If we use this formula for the other three earnings reports above we get the following results:
Earnings report two:
15.03 x 1.31
19.104 = 1.03
Earnings report three:
17.61 x .94
19.104 = .87
Earnings report four:
20.43 x .70
19.104 = .75
As you can see, some of these forecasts were relatively close to the actual move and others were quite different. Therefore, you may want to use a combination of this formula and simply view previous earnings reports on a chart to see whether the stock has a history of exceeding or falling short, and if so, by how much. But remember, past performance is no guarantee of future results.
Often a key determinant in whether a stock will increase or decrease in price after earnings are announced is how closely the results align with the consensus of analysts' expectations. Since this "surprise anticipation" is a measurable factor, another source for forecasting whether a stock will exceed or fall short of the earnings forecast is to use Schwab Equity Ratings.
OOTM (out-of-the-money) vertical credit spreads also usually benefit from implied volatility decreases, because while they involve both long and short options, the goal of a vertical credit spread is to receive the credit up front and hope that both options expire worthless. A sharp decrease in implied volatility, such as ones usually occurring right after an earnings announcement, will often cause both legs to drop in price and become virtually worthless, unless there is a substantial price move in the stock that is large enough to completely offset the effect of the volatility drop.
These strategies are most effective when you have a directional bias and you are trying to reduce the risks associated with the sale of uncovered (naked) options. For example:
- If you believe the earnings report will exceed estimates, consider an OOTM credit put spread (a bullish strategy).
- If you believe the earnings report will fall short of estimates, consider an OOTM credit call spread (a bearish strategy).
Consider the following credit put spread example using a fictitious stock ZYX, currently trading around $51.00, if there is no price change in the stock ZYX after an earnings announcement, but implied volatility drops 30%, pricing would be as follows:
Buy 1 Jun 21, 2014 45 P @ $1.55 Implied volatility = 60%
Sell 1 Jun 21, 2014 50 P @ $3.10 Implied volatility = 54%
Net credit = 1.55
Implied volatility decreases by 30%
Sell 1 Jun 21, 2014 45 P @ $.30 Implied volatility = 30%
Buy 1 Jun 21, 2014 50 P @ $1.30 Implied volatility = 24%
Net debit = -1.00
As you can see, the net profit would be 0.55 (1.55 – 1.00) strictly due to the reduction in volatility.
Strategies that benefit from implied volatility increases
OOTM vertical debit spreads usually benefit from increases in implied volatility because while they involve both long and short options, the goal of a vertical debit spread is to pay a small debit up front and hope that both options expire ITM. A sharp increase in implied volatility (unless accompanied by a large price move), such as those usually occurring right before an earnings announcement, will often cause both legs to increase in price. The higher value long option will typically gain value faster than the short option.
Like credit spreads, these strategies are most effective when you have a directional bias and you are trying to reduce the cost associated with the purchase of long options. If you believe the stock price will trend higher before the earnings report, consider an OOTM debit call spread (a bullish strategy). If you believe the stock price will trend lower before the earnings report, consider an OOTM debit put spread (a bearish strategy).
Strategies that mostly neutralize changes in implied volatility
As we've just seen, changes in volatility can often cancel out price changes or provide profitable opportunities even when there's no price change. But suppose you want to try to profit from an anticipated stock price change and avoid the complications created by the volatility component? Consider ATM vertical call spreads and ATM vertical put spreads.
Vertical spreads that are considered ATM usually have one leg just slightly ITM and one leg just slightly OTM. In most cases, the implied volatility of the long leg and short leg will be very similar, so any changes in volatility after the position is established will have very little impact on the net value of the spread, because they will largely cancel each other out. However, ATM options typically carry the largest time values (relative to ITM or OOTM options) so they are also quite sensitive to price changes.
What to keep in mind
- While implied volatility spikes before earnings announcements will generally cause calls and puts to increase in value, those increases could be partially or completely offset by large price moves in the underlying stock.
- Similarly, while implied volatility declines after earnings announcements will generally cause calls and puts to decrease sharply in value, those decreases could be partially or completely offset by large price moves in the underlying stock.
- While it is beyond the scope of this article, other strategies that may benefit from an increase in implied volatility include: ITM vertical credit spreads, short butterflies, short condors, ratio call back spreads and ratio put back spreads.
- Likewise, strategies that may benefit from a decrease in implied volatility include: ITM (in-the-money) vertical debit spreads, long butterflies, long condors, ratio call spreads and ratio put spreads.
I hope this enhanced your understanding of options strategies to consider during earnings season. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)
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