Here Come the Earnings…

It’s the broken record that we traders love to play again and again. While the process is the same, the outcome is almost always different. Earnings season is often a catalyst for change in a stock’s direction, volatility, and even sentiment. It can also simply accelerate a trajectory or cause a stock to do nothing at all, but regardless, just about every investor needs to be hyper-aware of earnings dates, especially the ones that involve your stocks or their peers.

Alcoa AA is the supposed grand marshal of this quarterly parade, but even though there are some stocks that will report sooner, the aluminum giant’s reporting date should be noted, as the weeks following Alcoa’s report is when the bulk of S&P 500 companies report.

Sectors and their leading stocks tend to report in clumps within a short time frame of one to three days. So if you know a large retailer is reporting, chances are that a comparable peer’s report is not far away. Peers can obviously have an effect on each other’s stock price and more often than not, a negative report by one stock in a sector will have a negative effect on the others and vice-versa. Some traders call this phenomenon “falling in sympathy.”

As an options trader, there are pros and cons to this heightened awareness and potential volatility. It really depends on your positions going into an earnings report and the type of strategies you plan to employ.

Implied volatilities in earnings months are typically elevated compared to other non-reporting months. As the stock approaches the actual release date, implied volatility may continue to rise, which is not to be ignored as discrepancies between observed and implied vol can diverge sharply. Heightened or reduced implied volatility reflects options traders’ collective opinion of a stock’s movement on the news and can be used to gauge expectations of movement. These implied volatility levels are, however, far from a guarantee. If you are traditionally a buyer of premium, you may be purchasing a high amount of implied volatility, which may leave you susceptible to large drops in IV. Check the vega of your options to know where your sensitivities lie!

Furthermore, because of the elevated volatility, spread strategies, which involve the simultaneous purchase and sale of options, may help mitigate the effects of large changes in implied volatility because the spread neutralizes the vega risk of each individual option.

Spreads may also help reduce your delta risk. Let’s imagine, for example, that you are bullish on a stock and are thinking of buying a 50-strike call on a stock with a delta of 0.65 and a vega of 0 .54. If you wanted to reduce your risk, you may consider looking at a vertical spread if you have an idea of how far you think the stock will rally. Remember, of course, that this strategy limits your potential profit. If you were to sell another call, such as a 60-strike call with a 0.39 delta and a vega of 0.58, you now change the dynamics of your position to a net long delta position of 0.26, while your vega is now net short 0.04. When stocks rally, implied volatility tends to come in. This spread position, especially in an elevated volatility situation ahead of an earnings report, will not only offer you a more neutral-to-negative vega position, but a cheaper, lower-delta risk profile.

Of course if the stock just explodes to the upside, you may miss out on some potential profit. If it drops, you will have less money at stake than a long call, which the maximum risk is the entire premium paid.

As we approach the next earnings season, I will bring you weekly hints and tips for trading options in and around numbers.

Photo Credit: Kevin Collins

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