What are Earnings and why do they matter?

Earnings refer to publicly traded companies announcing their revenues, profits and forward guidance to let the public know how they are doing financially. These announcements are usually made on a quarterly basis. Positive earnings announcements tend to quickly boost the share price of a company, but what is considered a positive announcement? Simply posting a profit that was better than the previous quarter does not necessarily mean the company did well. What is important for traders and investors is whether the actual figure beats the expected figure that analysts have come up with beforehand. For example, retailers tend to perform better during the holiday season and this is factored into the calculations analysts use when computing the expected figures for the earnings announcement. Naturally, these expected figures would be higher than the expected figures of the previous quarter because all retailers are expected to have more sales. If the retailer announces a profit that is lower than the expected figure, the stock price tends to go down even if the profit was an improvement on the previous quarter. 

Another important factor to consider is the Guidance a company. Guidance refers to the information released by a company regarding estimates of future earnings and estimates of other important financial figures and factors relating to future growth. In recent times, the market has seen a shift in focus from revenue and profits to the forward guidance of the company.

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Why Trade Earnings?

Earnings announcements provide a big increase in the volatility of a stock. This is because the announcement reveals new information, this new information is compared to the estimates that analysts have come up with the stock will have to be priced accordingly based on the new information that has just come out. This adjustment is done very quickly as soon as the earnings announcement has taken place. While earnings provide a scenario for a trader to profit very quickly, he/she can also lose money just as quickly. Options can be used to mitigate the risks of a trade going the other way by providing a scenario with limited risk and unlimited upside.

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Why use Options to trade Earnings?

As mentioned before, options allow investors to gain exposure to the movements of a stock while limiting the downside risks...for a premium paid in advance. Earnings announcements provide an ideal environment to use options as the vehicle of choice to speculate on a stock. This is because the big increase in volatility allows for the trade to become immediately profitable and surpass the breakeven price very quickly. If the trade goes in the other direction, the trader simply loses the premium paid, which is usually much less than the loss of buying the stock itself! The increase in volatility decreases the chances of the option expiring worthless and not surpassing the breakeven price during the life of the contract. It also protects the investor from very bad losses if the trade does not go according to plan.

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Factors to consider (the Greeks):

There are always three important factors to consider when trading earnings:

• How large the stock price moves after an earnings announcement (delta)
• The volatility crush (Vega)
• Time Decay (Theta)

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Delta – Delta refers to the change in price of the option with respect to the change in price of the stock. Out of the three factors listed above, delta is the only factor that can either have a positive effect on the trade (if the investor guesses the right way direction of the stock) or a negative effect on the trade (if the investor guesses the wrong direction). Options with a high delta will have a more erratic price move after an earnings announcement. When trading earnings, it is important that the large move in the option price is 1) in the direction that the investor speculated and 2) is greater than the sum of the volatility crush and time decay.

Vega – Vega refers to the change in price of an option with respect to the change in implied volatility of the stock. Volatility will always work against the investor when trading earnings due to the volatility crush after the announcement. The implied volatility decreases after the earnings announcement and in doing so, decreases the value of the option as well. 

Theta – Theta refers to the change in price of an option with respect to the change in time (measured in days). Theta always works against investors holding a long position in an option’s value is eroded with time. 

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At first glance, the Greeks can be quite intimidating to new traders. While it is important to understand the Greeks at a basic level, the OptionsPlay platform allows traders to experiment with the Greeks and see how they affect the option price without having to do calculations themselves.  Based on how the Delta, Vega and Theta affect the value of an option during earnings announcements, what are the conditions for an investor to be profitable with a trade? If the investor guesses the right direction of the stock after the announcement, he will only have one factor working in his favour (the large move in his direction) and two factors working against him (the volatility crush and time decay). So even if the investor guesses the correct direction of the stock, the large move of the stock should overcome both the volatility crush and time decay combined to be a profitable trade:

Trading Strategy

There are two strategies that can be implemented to trade earnings announcements:

• Long call/put
• Long call vertical/put vertical

Verticals are better suited for stocks that will not experience a massive move after an earnings announcement. Blue Chip companies tend to show more modest moves after earnings (3%-4%) and may be better suited for a long vertical strategy. Irrespective of which strategy is chosen, it is better to pick options that expire 1-2 weeks after the earnings date.

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Summary

Earnings announcements provide a great opportunity for investors to profit from large movements in stock price. However, trading earnings can be tricky due to a number of factors that have to be accounted for– price direction, volatility crush and time decay. For a trade to be profitable, not only does the price have to move in the direction that the investor speculated on, the large movement in the share price should also overcome both volatility crush and time decay combined. Two popular strategies that investors use to trade earnings are:

• Long position in call/put
• Long position in call vertical/put vertical

Each strategy comes with its own pros and cons and the investor should pick a strategy that is best suited for his/her view of where price will go. Factoring in the Greeks into the decision-making process can make things more complicated. However, OptionsPlay’s platform takes care of the complex calculations arising from the Greeks and allows investors to simply pick the best strategy suited to their needs.

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