How to Trade Earnings
In this post:
- What is the number one thing to remember when trading through the Earnings Season?
- Why are earnings trades sometimes called “lotto trades”?
- How can the market react to earnings?
With Earnings Season starting to heat up, a lot of traders always ask themselves how they should trade through the announcement. For those who are bold enough to take on the Risk, there are a few things to consider.
The number one thing to remember first and foremost is that earnings trades are 100% “lotto trades”. What do I mean by lotto trade? Well as we know, the market can react anyway around earnings, no matter how much we follow the technicals and charts as traders. Whether the announcement is good or bad or neutral, the market will react how it wants to. This means it could gap to the upside, to the downside, or have not much of a reaction at all and remain flat. Due to this uncertainty, this means any short term trade you put on to hold through the announcement should be considered a lotto trade. Much like if you play the lottery, you should be okay losing 100% of the capital Risk you hold on the trade if you hold it through the earnings announcement. Typically on trades like these I will hold only a fraction of my normal Risk tolerance, as I need to be okay losing the full capital amount. It also means I may pick and choose what companies earnings I want to trade specifically. If you start to trade every company’s earnings announcements, even if you keep your Risk small, you can find yourself with a lot of your prior profits eaten up if they don’t work out in your favor. So, once again, the number one thing to remember is that earnings trades are “lotto trades” and you need to be okay if the trade ends up going against you into a full loss.
The next thing to take into consideration when taking these trades is that Theta Decay is your friend. Theta Decay is your friend because you look to put on the trade prior to the announcement. Going into the announcement, due to the uncertainty of how the market will react to the news, typically the option strikes on the chain experience an increase in extrinsic value. Typically as you head into a normal weekly expiration, the strikes in the option chain will start to move toward their true value as there is less time for the underlying price to move against you. The out-of-the-money strikes lose their value and the in the money strikes match up in value with how far they are in the money vs the underlying price. This, however, is not the case when earnings are in the middle of that weekly expiration, even if the announcement is Thursday after market close and there is only one trading day left until expiration. Take into consideration AMZN. AMZN in general is a volatile stock but can be extremely volatile around its earnings announcement. Just from Thursday going into Friday for this weekly expiration, the anticipated move for this week still included almost a 200 point range due to that uncertainty around the announcement. This also means AMZN held onto that extrinsic value all throughout the week instead of experiencing theta decay like it normally would outside of earnings. Notice that the 3150 call, which is out of the money, still held over 41.00 of value in the strike Thursday going into Friday.
Now normally, AMZN can be volatile, so it is not surprising that it still held some value, but 41.00 is a lot of extrinsic value to be tied up in a strike that is 100 points out of the money with only one day left until expiration. This is all due to the earnings announcement.This is also not just exclusive to AMZN. GOOGL, for example, is not as volatile of a symbol when compared to AMZN, but still holds an anticipated range of over 60 points between earnings announcement in the afternoon and expiration the next day. Here on the options chain, going into the close on Thursday, a 50 point out of the money call still held over 11.00 of value on the strike.
Knowing that extrinsic value is going to be so high going into earnings, it is important for a trader to understand how that can benefit them when choosing a trading strategy vs choosing a trading strategy where theta decay could overall hurt the trade.
Many new traders automatically look at opening long Calls or Puts to hold through the announcement as they anticipate a gap move and think about the unlimited profit potential that a Long Call or Put can hold. However, this is how a lot of traders can lose money through earnings. It’s not to say every now and then the trade can’t work out, but it is a much Riskier setup where you have a lot more capital to lose. Take GOOGL for example. The anticipated range into tomorrow is 60 points. If you chose to open on Thursday the 1590 Call that is out of the money for an 11.00 debit into tomorrow, you may find yourself still with a losing trade. If GOOGL gaps down or remains flat on Friday after their announcement, then the theta decay will wipe out any value on this 50 point out of the money call and you will find yourself with a full loss. Even if GOOGL does move the 60 points to the upside, the trader who holds this strike at an 11.00 cost basis will still find themselves in a trade that is right near break even, rather than the big profit the traders were hoping for. This is because the 3190 strike was 50 points out of the money, if GOOGL gaps up 60 points, the strike will be 10 points in the money and hold a 10 dollar value and the extrinsic value decays away and the intrinsic value matches up with how far in the money the strike is vs the underlying price. If you got in at an 11.00 cost basis and the strike is only 10 dollars in the money at close, you still may find yourself with a 1.00 loss on the trade.
To avoid this potential pitfall when trading through earnings, it is typically a better idea to go with a strategy that is theta positive for your account, where theta decay is your friend. Things like Credit Spreads, Iron Condors and Iron Flies all fit within this category. My new personal favorite strategy to hold through an earnings announcement is the Unbalanced Butterfly. This strategy consists of a standard butterfly, with an additional contract on the credit spread portion of the trade. This means when you open the trade you typically open it for a net credit. The idea behind this strategy gives you a lot of flexibility through the earnings announcement no matter how the price moves due to the news. Take for example a PYPL unbalanced butterfly I held through the announcement.
For this trade I kept it conservative by opening an unbalanced butterfly on the Put Side that was outside of the anticipated range for this week’s expiration. This means if PYPL sold off on earnings, even if it was in the anticipated range, there was still a strong probability that I would walk away with a profit.
My net credit on the trade was .40. On a 2.50 width unbalanced butterfly, this means my Risk was 2.10, well within my overall Risk Tolerance, and much smaller compared to what I would look at for a new trade outside of earnings.
The benefit of the Unbalanced butterfly is that it can work out in a traders favor on multiple moves that could occur around an earnings announcement. If PYPL gapped up, like it did, then my unbalanced butterfly remains out of the money, the theta decay gets sucked out of the trade, and the net credit I opened the unbalanced butterfly for is a profit for my account. If PYPL remained flat through earnings, my trade still remains out of the money and I still walk away with a profit on the credit. Now you may be asking yourself, what if PYPL gapped down? Well this is where the butterfly part of the unbalanced butterfly can still help a trader make money. If PYPL gapped down and moved greater than the anticipated move towards my 175 short strike, then my Max Profit potential is actually the width of the spread plus the credit I received when I opened the trade.
2.50 width + .40 credit = 2.90 max profit potential
The reason why I could make up to 2.90 is because if the underlying price is at 175, I have the full profit potential on the contracts that make up the butterfly portion of the trade, and I have a full profit on the contracts that make up the additional Put Credit spread of the unbalanced butterfly.
Now I do still hold Risk on the trade of 2.10 per contract like I mentioned above. If PYPL had tumbled on earnings, outside the anticipated range and below my pin strike of 175, I would need to be okay taking up to a 2.10 loss on the trade. This is why it is always so important to understand the capital Risk you put into any trade, but especially “lotto earnings trades”.
The reason why I like unbalanced butterflies through earnings is because it gives you a lot of opportunities to take a profit depending on the move. In this scenario, a move up, sideways, or down (as long as it was at or above 175) would have given me a profit on this trade. The only time I would be hurt is if the price tumbled below 175. This is me is a much better trading strategy to hold through earnings when compared to a Long Call or Put, where not only do I need 1 specific directional move up or down, I need it to also be a strong move just to get me to break even or to be profitable on the trade.
Remember, trades held through earnings announcements should always be considered “lotto trades” however there are strategies out there that can still give you a better probability of taking a profit. Play smart not hard, and as always, may the trade be with you!
Does your trading strategy need refining? Or are you looking for guidance and mentorship? At Simpler Trading, we can offer both. Join Allison Ostrander in her Profit Recycling Mastery and get monthly live-trading sessions.