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Stock options allow the trader to buy or sell shares of a stock at an agreed on price and date. Earnings are released quarterly and show the actual profitability of a company.
Knowing this, should you buy or sell options right before earnings?
You should generally avoid buying or selling options before earnings. The market is volatile around this period, which is likely to lose you money in the long run.
Earnings will also lead to higher option premiums. However, there are strategies you can use to profit from options before or during earnings.
In this article I will explain what earnings season is and how it affects options. You will also learn about some strategies to be profitable with options close to or during earnings.
How Earnings Affect Options
Before I go into how earnings will affect options and why I feel it’s best to avoid trading options during this time it’s important to clarify what earnings are.
What Earnings Are
Earnings are a company’s net income after tax. Most companies release their earnings quarterly. These periods are one of the most important ones for stock prices, as the returns on the day of the announcements tend to be a few times greater than usual (either up or down).
Even after the initial “shock,” the earnings report can affect a company’s stock price over a more extended period but options are only good for a certain period of time so long term growth is not good for option traders.
How Earnings Affect Option Prices
Since the price of options contracts largely depends on the value of its underlying asset, earnings also have a significant effect on options. Not only that, but another factor that affects option prices is the volatility of the market, also known as implied volatility (IV).
Before earnings, IV tends to be at extremely high, leading to much higher options premiums. After the announcement, it tends to decrease pretty quickly once the news is out.
The main reason why IV jumps up so much before earnings is that there is a lot of uncertainty about the stock price since traders do not know whether it will trade up or down. Once the reports are released, there is no more uncertainty and implied volatility drops, and so do option prices.
So, if you have to pay a higher premium (which will usually happen around earnings season) you may have to sell the option for a lower price even if the stock moves in the direction you want it to. Many traders avoid dealing with options during earnings for this reason.
How To Measure Implied Volatility
Without doing math, you can use various sites online to calculate the IV of a particular stock for you. But how do you know whether the result you get is high, low, or average?
The best method to determine that is to compare the IV to the stock’s historical volatility for the same time frame. Contrary to implied volatility which measures expectations for future price changes, historical volatility measures the volatility that already happened.
When you compare these two, you can get an idea of whether the current volatility is high, low, or average, which can help you determine whether you should buy that option or not.
Should You Trade Options Around Earnings?
It is best not to trade options around earnings. Trading in highly volatile markets is generally not advised for newer investors since too much can go wrong and they can lose a lot of money if they take the wrong approach.
Additionally, this volatility will also increase premiums, which means that you will have to pay more up-front to buy the options.
However, you can undoubtedly profit during this period if you are more knowledgeable of the market. More experienced traders can make better analysis of certain stocks, which helps them take a bullish or bearish stance.
Here is how you can do the same:
- Stock forecast. This is the first step to take when buying an option, and it should narrow down the options significantly. When you have certain expectations about how the stock will move, you can use different options strategies based on whether you think the stock will go up, down, or stay put.
- Volatility forecast. The level of volatility in a stock is also essential to know. You can compare the implied volatility to the historical volatility to measure whether it’s high, low, or average.
Best Option Strategies for Earnings
It is not recommended if you are a novice investor to trade options during earnings, but that does not mean you cannot do it or that it cannot be very profitable.
Here are some well-known strategies you can use when trading options during earnings:
If you expect the earnings announcement to not significantly impact the stock price, you can use the short straddle strategy. This strategy implies buying a call and put option for the same stock at the same strike price and expiration date.
This strategy will be profitable if there is not a lot of movement in the stock price.
With a short strangle strategy, the investor sells a short call and put option of the same stock and expiration date when both are slightly OTM. The call has a higher strike price than the put.
When the stock price falls somewhere between the call and put options’ strike prices, the investor will profit. However, the risk of loss is unlimited when the stock price rises and substantial when it declines.
So, it would be best if you were very careful when using this strategy.
The iron condor strategy consists of two call and two put options, where you sell one and buy one of each. All have different strike prices and the same expiration date.
The goal of the iron condor is to profit from low volatility in the underlying asset. This happens when the price falls between the middle strike prices at expiration.
Novice investors should stay away from trading options around earnings. This period brings a lot of volatility to the market. Additionally, the premiums are higher.
However, with enough knowledge and the right strategy, options can be profitable during this time.
You can use many different strategies to trade options during earnings, depending on whether you think the stock will go up, down, or will not move much at all.