Trading earnings with options can be extremely profitable. It's possible to take advantage of the drop in volatility that occurs after the earnings announcement. By selling options you can sell options at inflated prices with high volatility and hopefully buy the options back the next day for a low price.

I've written a detailed description of a method for trading earnings announcements. Williams-Sonoma (NYSE:WSM) provides a great potential earnings trade using options. According to the earnings.com earnings calendar WSM's earnings release will be tomorrow morning. Currently WSM is trading at $30.03.

Looking at the option chain above for WSM you can see that the september options have an extremely inflated implied volatility at 73%. Compare this to the further out months where the volatility is around 50%. I've analysed the volatility drop following earnings for WSM. This analysis shows that WSM exhibits a volatility crash after the earnings announcement.

The key to making successful earnings trade is careful risk management based on a detailed analysis of historical earnings data.

The graph above shows the price changes for WSM in number of standard deviations following earnings for the last 5 years. The blue bars indicate close to close changes, the red is close to open data and the green is the intraday open to close data. The left side of the x-axis is the nearest previous earnings release and the right side is the last earnings announcement analysed (24/05/2006). Currently one standard deviation in dollars for WSM is equivalent to $1.09.

By looking at the close to open data you can see that apart from an outlier in 08/2006 the maximal range is from -3 standard deviations to +3.5 standard deviations. Taking the current dollar value of one standard deviation, the maximal expected price range after the earnings announcement will be between $26.76 and $33.85.

I expect the volatility after the earnings announcement to equalize with the volatiity of the further out months. This will mean a drop of about 20% in implied volatility. I'll select a safer drop of 15% for my analysis.

Above is the profit and loss graph for this earnings trade. The white line is the theoretical value of my position tomorrow after the earnings announcement taking into account a 15% volatility drop. The options I decided to sell is a SEP 27 strike put for $1.00 and a SEP 34 strike call for $0.70.

You can see that the profit range for my trade almost fits the maximal expected range for the earnings trade that I analysed previously. The profit range is extremely wide. Since the average close to open price change is 1.8 standard deviation, I can reasonably expect to make a profit of 20% on the initial credit of my position and the chance for loss is very small.

When selling options it's important to consider disaster scenarios that don't fit the historical model. Even taking into account an unexpected 15% price movement to either side the potential loss fits well within the 5% of total trading capital that I'm willing to risk on any trade.

You can follow my blog at The Options Trading Course to see more info on trading earnings announcements with options.

I've found this to be one of the most consistently profitable and safe trades out of any potential stock or option trade.

Disclosure: I opened a short strangle on WSM selling September options. I sold $27 strike put for $1.00 and a $34 strike call for $0.70.