How To Trade Earnings Announcements?

The earnings season has just started, a period of high volatility, which is a headache for many investors, but also full of opportunities for speculators. Long term investors seek to extract some new guidance that may change their views about the stocks they own, company CEO’s anxiously plan on soft ways of telling the truth about missing earnings, small investors pray for their stock to show some positive surprises, and speculators try to get the most out of the season.

The earnings season is a period of increased volatility due to the uncertainty surrounding earnings announcements. When some report is just near release, the price on that respective stock starts moving faster as investors try to guess what will happen. Will the CEO surprise us with better than expected numbers? Will he upgrade future guidance? How about gross margin, is it improving? How many phones did the company sold? And will the new Windows system create the hype others did? Those are just some of the questions waiting for an answer and agitating investors before the announcement event occurs. And even after it, it may take a day or so for all investors to adjust to a changing picture.

Under such circumstances it may be worth protecting a long stock position with a put option, for example. Instead of going naked through the release, an investor may buy some cheap insurance and protect for risks using what is known as a protective put strategy. A speculator short on the stock may adopt an inverse strategy by buying a call option. But these are strategies mainly tailored for someone already owning a position on the stock, just willing to hedge it.

For others looking for ways to explore the earnings season opportunities, a straddle may be the right call. This is the perfect strategy when you do expect price action but you do not know the exact direction of it. Basically you’re clueless about the direction of a possible earnings surprise so the best is to play both sides by buying both a call and a put at the same time.

A straddle is a neutral strategy involving the purchase of both a call and a put, for the same expiry date and at the same strike. For the strategy to be neutral, options should be at- or near-the-money, otherwise it would make a difference whether the stock goes up or down.

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The risk deriving from a long straddle is limited to the price you pay for the options while upside potential is virtually unlimited. But unlike a naked out-of-the-money call or naked out-of-the-money put strategy, which are very cheap, this strategy is rather expensive. Firstly, you’re buying at-the-money options, which are of course more expensive than worthless options. Secondly, you’re buying two options and not a single one. Because of this, you should only use the straddle if you’re really clueless about stock direction, otherwise you would be better with just the call or the put. At the same time, volatility needs to be high.

Let’s think on a simple example. Ebay is currently quoted at $55.88 and is expected to present earnings next week on July 17. Let’s say you believe there will be a huge surprise on its earnings and price move may be around 10% either side. Let’s try to set a straddle strategy to entrap that juicy profit.

Unfortunately there is no option for a strike of $55.88 or even to $56, so we will have to purchase the options with strike $55. This will distort a little the neutrality as you will see but the real world is imperfect and we just can’t reproduce the theory perfectly. The call is currently quoted at $1.91 while the put is trading at $1.02. If we buy 10 contracts (100 options each contract) of each, we need $1,910 plus $1,020 or a total of $2,930.

Let’s now suppose EBay shows much better than expected results such that its stock rises 10% to $61.47. If we let the options expire holding them until July 18 (or near it), the call would be worth $6.47 each while the put would be worthless. With 10 contracts at our hands we would sell the calls for $6,470, for a $3,540 profit, or 120% return. If, results weren’t that good and EBay ended declining 10% to $50.29, then our calls would be worthless while the puts valued at $5.59 each. Our total profit would then be $2,660, or 91%. If the options had an at-the-money strike, profit would be equal up or down, as we stated above. Unfortunately that’s not the case.

As you can see the straddle is another way for you to effectively trade uncertain events that bring volatility up. It’s a costly strategy but one that we want to have handy under certain conditions.

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