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As you’ve learned from previous editions of Profit Talk the probabilities for success are higher for credit style option strategies. These strategies use short options as the primary profit driver. This type of trade is also called a short option or short premium style strategy. Short option strategies are versatile and can be used to create bullish, bearish or neutral type investments.
You have also learned that short premium strategies perform best when used in markets experiencing elevated levels of implied volatility compared to the historical range found in the particular market. This relative level of volatility is measured and given a value called “Implied Volatility Percentile” or IVP for short.
Implied volatility is simply a measure of the current option premium levels. Short option strategies perform better when entered during high IVP levels because they are short premium strategies and “short trades” profit when the asset shorted falls in price. Selling premium at high levels, relatively speaking, provides opportunity for profit when this “high premium” level normalizes and falls back to it’s average. That is the basis for selling options when the IVP is high.
Currently, the majority of the markets are experiencing very low IVP as we are at all time highs in the markets and the fear level is very low. This makes for very low option premiums and therefore can be challenging, and frankly, a bit boring for those of us who like to use short premium selling strategies. Fortunately, there is relief for those of us “starving” for short premium trades. This relief comes to us through what is known as earnings season.
As an options trader some of the best times of the year to trade is during what’s referred to as earnings season. The majority of the largest and most influential companies in the US start releasing their numbers 3 or 4 weeks after the quarter ends and continue doing so for about 3-4 weeks from that point. The high volatility that is generally associated with earnings season provides plenty of opportunity for options traders.
Earnings season is an especially enjoyable time to trade for those of us who like instant gratification. The anticipated earnings release usually causes a rise in IV Percentile because of the unknown outcome from this binary event. A binary event has an equal chance of creating price movement in either direction. The premiums are driven higher by those who are purchasing options as insurance for their investment and by those who are speculating in the particular markets.
As is the case with premium prices in general and especially when at the higher levels, premium prices are overstated compared to the actual historical moves that occur. So, those willing to sell premium at the edges of the expected range are usually rewarded for taking that risk. The inflated premium prices usually collapse once the earnings are released, so these trades are generally held for one night only.
There are exceptions, such as when price breaches one of our strikes and we’re forced to either roll or “babysit” the position to defend the loss. This does happen and should be planned for, not feared. The best defense is to keep your size in check, meaning keep trades small, and be faithfully active during earnings season to provide enough occurrences to make up for any of the losers.
I use the defined risk of Iron Condors exclusively when trading earnings on individual names, but I will use undefined risk Strangles or Straddles for sector ETFs which hold the individual names. Much of the time the associated sector ETF will mirror a fair portion of the IV increase that the company’s it represents are seeing. But, the risk of a huge gap move against the position is far less likely in the ETF. However, unlike the individual name, which experiences a large collapse in volatility after the news has been released, the ETF will hold onto it’s IV Percentile level until all the biggest holdings within the ETF have released their earnings. So, when placing this type of a trade in an ETF, it’s generally best to wait until a good portion, say 2/3 - ¾ or so of the holdings have released earnings, before placing the trade. This way you won’t have to hold too long through all the various releases while hoping the EFT stays within the range. But, of course once all the risk is gone, the premium will be gone as well, so don’t wait ‘till the very end or they’ll be no trade left in the ETF.
An example of this is to sell Iron Condors on the biggest US retailers for their individual releases, but once ⅔’s or so has reported, sell a Strangle on the retail ETF ticker XRT. But, remember, it’s best to use option selling strategies in high IVP situations. Follow the Strategy Match rules even when trading earnings. The correct IVP level for selling a Strangle is 80% or higher and for an Iron Condor, the IVP should be 60% or higher. If the IV is not high then it’s not worth selling premium. The details of constructing and analyzing the risk profile of an Iron Condor was covered in the 11/28/16 edition of Profit Talk called “Credit Strategy Risk Analysis”.
I will add a caveat to this statement. The severely low implied volatility situation means very few if any ETFs are obtaining very high rates of IVP during this earnings season. Because of this, I’ve personally temporarily lowered the standard when it comes to IVP. But, don’t sell too much premium at low IVP levels. Keep small and keep a fair amount of “powder dry” as they say. I don’t when it will happen but I know for sure that volatility will return. When it does, you don’t want to have too much short premium sold a depressed prices.
During the peak of earnings season finding opportunities is typically not a problem. We can search for them on free websites like the calendar page of Earnings Whispers https://www.earningswhispers.com/calendar . (Figure 1)This website is simple and provides the information needed. You can look by date to find scheduled earnings releases or search for a particular symbol using the search tool at the top of the page.
This website also allows you to sort by the scheduled report time. Knowing the time the earnings report is released is a critical piece of information when implementing an earnings strategy. Most companies report either before the market opens or after it closes. Earnings Whispers website allows you to sort the list for companies reporting before the market opens “BMO” or after the market closes “AMC.
Another website to use is the Yahoo Finance earnings calendar page at https://biz.yahoo.com/research/earncal/today.html . You can search by ticker symbol or date. The time of release information is in this column. (Figure 2)
In addition, many trading platforms have filters for earnings release information. The TD Ameritrade “Think or Swim” platform has the ability to search for earnings information using the scan filter. To create a scan query to filter for companies by earnings release date, go to the scan page. Choose the stock universe to filter under the “Scan in” tab, use the drop down menu and under “Category” choose “All Optionable”. (Figure 3)
Create the two filters used on every scan query which are stock minimum share price and daily volume. Add the stock price filter by clicking on the “Add filter for stock” button. Use the drop down menu and select “Last”. This stands for “last price”. My minimum is $15 per share. I don’t like to trade stocks below $15 in most cases. (Figure 4)
The next filter to create is for stock volume. Click the “Add filter for stock” button, use the drop down menu and select “Volume”. The minimum daily average volume I’m looking for is typically 1,000,000 shares. And, the reality is, the markets with far more volume than 1,000,000 per day are better to trade. Your odds of success are higher when trading the highest volume stocks. A good strategy is to start with 1,000,000 as a minimum and then sort the candidate list by highest volume.(Figure 5) Use the top of the pack as your short list of prospects.
Now create a filter to search for earnings releases. This search uses another type of filter called a “Study Filter”. Click the “Add study filter” button to add the filter. Use the drop down menu to look under “Corporate Actions”. Select “earnings”. Set the parameters to “Has” and earnings announcement “Any time” in the next number of bars. The default is daily bars. For this example, put 7 bars. This filter will look for companies that have earnings releases anytime in the next 7 days. (Figure 6)
Click the scan button to create a list of candidates. The prospect list can be sorted by IV Percentile or Volume or by many other statistics. The earnings report dates and other information can be found by hovering over the icons in the symbol column. (Figure 7)
As far as timing these trades, we always put them on prior to and nearest in time as possible to the release. This means, the later part of the day on the last trading day prior to the release. As mentioned, most releases occur either after the close or before the open of the regular trading session. Earnings trades on companies that release before the market opens “BMO” should be entered prior to the market close on the day before the release. Trades on companies that are releasing after the market closes “AMC” should be entered before the market closes on the day of the release. Anytime in the last few hours of the trading day is fine and even early is the day is okay if necessary based on circumstances.
Most often I use Iron Condors for earnings when trading individual companies. That is because they are non-directional and have defined risk. The amount that can be lost on the trade is limited. There is no real technical analysis involved, although I do like to use supply and demand zones to help choose strikes. It is a must to look at several past earning releases to get a feel of how much the price gaps when earnings are released. Earnings release announcements can cause a very large move in price while the market is closed. This will cause what is called a price gap. A price gap is a huge gap in price, either up or down when the stock opens the next day, compared to the closing price the previous day. That’s why the options are generally very expensive right before earnings are released. If there was no risk there would not be any premium.
The profitable earnings trade is based on surviving the move. Once the report is released the stock will react, and if it remains within the range your position calls for, it will be profitable. In most cases the premium collapses the next day following the release. This is especially the case when price ends up remaining a fair distance away from the short strikes.
In most cases we buy back the position to close the trade on the next trading day following the release.
It is important to follow the rules on the particular trade and especially the reward to risk. If you are not familiar with the reward to risk analysis process, review the 11/28/16 edition of Profit Talk called “Credit Strategy Risk Analysis”. In short, make sure to get enough premium to cover the risk.
Earnings releases can cause huge gaps in price in either direction, so choose strikes far enough away based on the historic earnings moves in the particular underlying. It is normal to have a few go against you each earnings season, it is rare to have none go against you if you’re active.
Don’t let this discourage you, they are well worth the occasional headache move that occurs.
Trade with smaller size and trades multiple markets in different sectors over the many weeks of heavy releases. Keeping active smooths out the results.
Use an expiration as short as possible but don’t settle for too low of a premium.The risk profile must be analyzed and a 1:1 minimum reward to risk maintained as mentioned. The idea is to use the shortest expiration as possible because that’s where all the earnings IV is.Then exit the next day.
But, the shortest duration options don’t always carry enough premium to get far enough away to survive the move. This may force us to go out further out in time to get enough premium to choose strikes outside of the range. Doing this will result in less immediate volatility collapse than what would occur in the shortest duration options. In this case it may take a few more days or a week or so before the profit target is reached depending on your choice of exit.
If you recall from our analysis of the short Iron Condor, (Profit Talk 11/28/16), you can use the risk graph and set the date to get the expected range for price to close within the date specified. We don’t use the next day as the date for the risk graph even though we’re planning on exiting then. The expiration date of the option contract should be used as the earnings move is priced into the range, and as always, it’s based on the expiration date of the contract.
To select the specific short strike, the same rules should be used as with a standard Iron Condor. Start with a delta value of +/-.15-.20 delta. Adjust the long “protective” strikes according to risk graph analysis and personal risk tolerances. The general rule is choose long strike locations as close as possible while maintaining enough premium credit per our minimums.
Keep in mind we need 25 cents minimum net premium from each side of the spread so the credits need to be at least 35 cents to spend 10 cents for example on the long option. Ultimately strike selection needs to adhere to what’s found from analysis of the chart and historical information.
Take a historical look back of at least a few years of earning releases to see the most extreme moves that have occurred and make note in percentage terms. Then look at the present condition of the chart and make note of the demand and supply areas beyond where the biggest previous percentage earnings move would take price today. Ideally, these are your strikes. Or, at least it’s a place to start and put some context around price.
As far as closing the trade there is basically two schools of thought
One that says that the trade is a binary event trade and should be closed once the event has passed no matter what the outcome
And the other side that says that if it was entered using our standard measures for success then the probabilities should be allowed to play out as always. I tend to lean more towards the latter but am aggressive about profit taking the morning after the release.
I remove positions that morning which have reached 30% or more of the possible profit. I also remove trades where price moved a fair amount and is possibly threatening my short strikes, but I’ve benefited enough from volatility collapse that the trade is close to breakeven. Perhaps it’s a small winner or loser. In that case, I’d prefer to close out instead babysitting a trade starting the second day I’ve opened it and I see the ability to do it without losing anything as a win.
Trades I will manage are those where price has remained fairly close to the middle of the strikes but premium did not decay enough yet. These I see as any other Iron Condor I may have put on and am OK with holding for a few days or so to get to at least the 50% of profit point. I also manage any losers by rolling out in time and strike if necessary once the risk defense point has been reached or if breached at the open. Though, I don’t execute any of this immediately upon the open in most cases as the markets needs the first 15 minutes or so to “settle down”.
When it comes to managing risk on earnings plays it’s important to keep the trade size small, especially for the first few cycles you go through. It’s fine in this case to not use the full risk amount normally allotted per trade until gaining some experience in this type of trading. It’s important to have respect for some of the moves that can occur when there is a surprise in the report, either good or bad. Even when using defined risk trades like Iron Condors don’t be complacent and keep in mind the absolute max loss amount as determined by the width between the short and long strike. Gaps created by these events are exactly the kind of situation that can create a maximum loss scenario in a position.Never enter a trade with a larger maximum loss amount then you can handle if it were to occur.
In terms of example trades for this strategy. As covered earlier, the best results from this type of strategy come with a high amount of trading activity. For this reason, consider creating small positions in several of the top volume markets among the scan results. Continue running the scan throughout earnings season and stay active entering and closing the trades.
The main takeaways when it comes to trading earnings announcements are
First, stick to the highest volume names experiencing the highest IVP
Second, use defined risk strategies on individual companies like a short Iron Condor
Third, use smaller trade size and keep as active as possible.
Okay, here we go with the same report again. I feel like I could just copy and paste the last month’s worth of Market Outlook reports. The major markets are still stuck in a range, maybe earnings result will bring some near term consensus in the market and get things. This sideways price action has been good for last edition's Calendar spread on the Nasdaq 100 ETF. The spread itself has not realized much profit but the longer this persists the better the results of that trade will be.
The high impact reports schedule for release this week are:
Tuesday 1/24 - Existing Home Sales
Wednesday 1/25 - Crude Oil Inventories
Thursday 1/26 - Unemployment Claims
Friday 1/27 - Advance GDP and Core Durable Goods Orders
A Look Ahead
Next edition of Profit Talk we’ll focus on the subject of trade management as we cover details of how to roll trades to manage risk.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at email@example.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.