- 2001: Volume 10, No. 1 Puts & Calls: Taking Advantage of Earnings Season with Winning Option Plays

I feel like a mosquito in a nudist colony—I just don’t know where to begin. If there is one certain thing in the market, it’s that nothing is certain. Just when it looks like you have this whole trading thing figured out, the market shows you in no uncertain terms that you don’t. It is the volatility in the markets, though, that gives traders opportunities to register nice returns on their money. News events move stocks and the single biggest news event is earnings. For traders this is wonderful, since earnings are being announced daily. Sure, there is seasonality to the majority of earnings releases, but even this occurs four times a year. Conversely, prior to earnings season is the warnings season. This time is usually negative for stocks as warnings of earnings shortfalls usually dominate the news. But once this time is over, the actual announcement by companies of their financial situation is normally positive for the market. Since earnings season is a great time to trade, let’s take a look at how to find the best stocks to play options on.

There are a couple of generalities that I need to discuss before delving into the specifics:

1. Option volatility tends to fall in a time of little news and riseswhen important news events are pending.
2. After the news has played out, option volatility tends to fall,sometimes drastically.
3. Companies that historically have beaten earnings estimates tend torise ahead of earnings.
4. The conference call after the announcement has more impact on thefuture of the stock then the actual announcement.

Just prior to this article being written, Yahoo! (YHOO) announced earnings. It is no secret that the tech sector has been lambasted over the last six months and Internet stocks have taken the biggest beating. YHOO has fallen from an all-time high of .06 on January 2, 2000 to a low in the mid-20s. The stock at one time was a classic example of "buy the rumor, sell the news." Take a look at Yahoo’s chart to see what I mean (see Figure 1).

Figure 1:

For the better part of year, Yahoo! had become very predictable. Traders bought in advance of the company’s earnings announcement and then sold on the news. Notice how eventually this strategy no longer worked, as traders started buying earlier and earlier. This resulted in selling in advance to stay ahead of the crowd. Each yellow block in the chart is roughly three weeks to a month of time.

So now the question becomes, "How do we find stocks that show this type of predictability?" The first thing to do is put together a list of optionable stocks that are scheduled to release earnings in the next four to six weeks. This list will be quite long during the earnings season. After compiling a list, check past earnings on the stock. If the company has had a history of beating earnings estimates, check the chart. It is likely that the stock has a history of going up heading into the announcement. This becomes a good candidate to play options on.

Anyone who has followed the market for long knows that oftentimes news that seems positive results in a market drop and vice-versa. Much of this has to do with expectations. The market is the greatest discounter of news the world has ever known. Many times stocks will price in an event that seems likely to happen. This is what happened with Yahoo!. Notice on the chart how the stock fell sharply after nearly every earnings announcement. Trust me, this was not because the company announced bad news. It happened because traders got their gains and then sold on the earnings news.

There are a couple strategies to look at when playing options on earnings news. One is placing bullish strategies ahead of an announcement. The other is waiting for the announcement and then placing strategies that fit the type of earnings news the company announces. Let’s take a look at each approach.

Pre-Earnings Strategies
After finding stocks that tend to outperform earnings estimates and verifying that the stock does tend to find strength in the announcement, it is then time to check the options. Remember one of our generalities was that volatility tends to rise heading into earnings and fall after the event. If a stock’s historic option volatility is already extremely high, placing a strategy that brings in a credit is often the best choice. My favorite way of doing this is to place a bull put spread. A bull put spread consists of buying a lower strike put and selling a higher strike put with identical expiration dates. This type of strategy takes advantage of high volatility since it is likely to revert to the norm. Regardless, as long as the stock stays above the chosen short strike, the net premium received is maximum profit available. The breakeven is calculated by subtracting the net credit received from the higher short strike price.

If the volatility is slightly above average or lower, buying premium is usually the best strategy. As more and more traders buy into the rumor of good earnings, volatility will rise. This often will leave you with a profit, even if the stock does not move drastically. A bull call spread—the purchase of a lower strike call and sale of a higher strike call with the same expiration dates—is a great way of taking advantage of the stock’s likely rise. Holding any short-term options through the actual announcement, however, is very risky. As I mentioned earlier, it is hard to predict how a stock will react to its earnings announcement.

Post-Earnings Strategies
If you aren’t the type of trader that likes to play short-term options, then another way of taking advantage of earnings announcements is to wait for the actual release from the company. Back in 1997, Barron’s had an article about a Merrill Lynch poll that asked 122 institutions their favorite strategy. The most common answer was buying stocks that beat earnings estimates and selling stocks that fell short of expectations. This makes sense, as earnings are the main driver in any stock’s long-term move.

If institutions are buying or selling a security, it will definitely affect the stock’s movement. If a stock beats earnings estimates sharply, then placing longer-term bull strategies would be appropriate. This could include LEAPS (options with up to three years until expiration) if they are available. Bearish strategies can be used if the company falls short.

The above information will, more often than not, help an option trader be successful on trading earnings news, but there are other things that can be done to put the odds even more in your favor. This includes checking the sentiment on the stock by looking at the put/call ratio. If traders are extremely bullish on the stock (shown by a high ratio of calls to puts) then the stock may have trouble rising substantially and will likely fall on the earnings announcement. The opposite also holds true. A trader should also look at the overall attitude of the market and sector the stock trades in. If other companies in the same sector have been warning of earnings shortfalls, it isn’t likely your stock will rise much heading into its announcement.

Overall, the best way to master the concept is to practice, practice, practice! Track stocks that you like and paper trade them. Learning the trading patterns of a few stocks can help you predict future movement in the equity, resulting in larger profits. The school of hard knocks may be the best education a trader can get, but I hope this article will act as a seat belt to help protect you while learning to trade successfully.

Joel Addison is a Senior Writer and Options Strategist for Optionetics.com, a stock and options-oriented Web site dedicated to empowering investors through education. Comments and questions on this article can be sent to jaddison@optionetics.com.

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