Profiting From Earnings Announcements
Earnings announcements provide profit opportunities for astute options traders. The great thing about earnings announcements is that they are extremely well-defined events that are easy to measure statistically and upon which trading models can be built.
Stock traders are at a disadvantage compared to option traders since stock trading relies purely on a directional play. No matter how good your technical analysis or market psychology or fundamental analysis, the stock trader has basically a fifty percent chance of being right. He goes long, he can profit from a rise in price; or if he goes short he can profit from a fall in price.
The beauty of options trading earnings announcements is that options allow us to profit within a range of potential prices, so we can generate consistent income regardless of whether the stock goes up or down in price.
There is also a secret advantage of options trading earnings plays. Often, for many stocks, volatility tends to rise prior to earnings announcements thus inflating the price of the options. Sometimes the price becomes so inflated that selling the options at inflated prices becomes extremely attractive. Abnormal market events such as the recent market crash and high volatility can tend to accentuate these volatility hikes. Yesterday with the major indices falling around 5% definitely aided this option trading strategy.
Following the earnings announcement, the volatility of many stocks tends to crash. Hence the following day the options that you sold at hyper-inflated prices can be bought back for bargain basement prices netting a nice profit. This volatility crash is accentuated greatly by the proximity to options expiration.
Option Trading Strategy for Earnings: Selling Options
Case study of Earnings Announcements Option Trade with Marvell Technology (MRVL) Options
Marvell Technology provided a great option trading opportunity yesterday. As I mentioned earlier the basic strategy involves selling options. Specifically the options trading strategy that I usually implement is opening a short strangle or short straddle, depending on the stock. For MRVL however, following a detailed historical analysis of price movements around earnings, I decided to simply sell puts, otherwise known as opening a short put position.
Historical Analysis of Price Movement of MRVL stock following earnings announcements
Above is historical analysis of the price change of Marvell Technology (MRVL) stock following earnings announcements. In blue is the close to close change, red is the close to open change and green is the intraday open to close change.
To define my margin of safety I simply take the extremes of earnings announcement price changes. I use the close to open figures since the range tends to be tighter than for close to close price changes. In this case the extremes were -3.7 standard deviations and +8.4 standard deviations. Taking into account current volatility, this translates into a price movement of -12% and +22% respectively.
Since the price changes are skewed to the positive direction so significantly, this rules out opening a short strangle or short straddle strategy for me. Hence in this case it made sense to sell options. In this case selling puts was the preferred strategy, since it is biased towards an upwards price change movement after the earnings announcement.
From the Marvell Technology options chain above, you can see the amazingly elevated volatility! This is far above the normal volatility elevation since we are in the context at the moment of a major market correction.
It is important to note that my analysis for this option trading strategy uses historical price changes in standard deviations. Analyzing this trade using percentage price changes could be potentially dangerous since it underestimates the effect of volatility on the price movement. Using standard deviations will take into account the current elevated volatility and will improve my margin of safety for this trade. Of course it eliminates many possible trade candidates, but it is better to live to trade another day!
MRVL closed at $12.10 prior to the earnings announcement. This options trade involved selling MRVL August Puts with a strike price of 11 for $0.39 each. I sold 50 contracts. The implied volatility priced into these options was a tremendous 350%!
With this position my upside is not threatened at all. To the downside, taking into account time decay alone, the profit range to the downside is -7%. However since we expect volatility to crash, in this case by at least 100%, the profit range to the downside starts from -11%.
This earnings trade afforded me a good margin of safety. In after market trading the direction looked positive, with the last trade at $13.25 (an increase of almost 10%).
In summary, trading options around earnings announcements can be highly profitable and can afford a wide margin of safety. While option trading can be risky, in the case of trading earnings announcements, options are safer than stock trading!