Lessons From Earnings Plays

by: SteadyOptions

There are many ways to play earnings. Some people prefer to play them directionally, buying calls or puts. I think that earnings are unpredictable; hence I prefer to play them non-directionally.

As described in my article 'Whatever You Do, Don't Do This Before Apple's Earnings', buying either calls, puts or both (straddle) before Apple's (NASDAQ:AAPL) earnings report was, on average, a losing proposition. However, this cycle was different. An ATM straddle purchased at the close before the earnings day and sold at the close the next day produced an impressive 49.42% gain. But is it a rule or an exception?

I decided to check how some of the popular high flying stocks performed this earnings cycle. The following table presents the results. The "expected" move was based on the price of the ATM straddle before earnings.

As we can see, most plays would be losers. Even including an historic move from Green Mountain Coffee (NASDAQ:GMCR), the average return is still negative. Remove GMCR, and the average loss grows to -22.57%.

It is easy to get excited after a few trades like GMCR or Amazon (NASDAQ:AMZN). However, we have to remember that those stocks experienced much larger moves than their average move in the last few cycles. In some cases, the move was double or triple that of the expected move. A move like GMCR can happen maybe 3-4 times per year. There is no reliable way to predict those events.

The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit - see Netflix (NASDAQ:NFLX) case.

Google (NASDAQ:GOOG) had a decent move, but the straddle still lost 36%. Baidu (NASDAQ:BIDU) hardly moved and the straddle experienced a massive loss. Are you ready to swallow those losses?

My favorite way to play earnings is to buy straddle (or a strangle) a few days before earnings and sell it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising implied volatility (IV) of the options before the earnings. I described the general concept here.

The strategy has performed well so far this year, despite a low IV environment. I'm not looking for home runs here (although I had a few when IV spiked), but consistent 10%-15% gains with relatively low risk. You can see the 2012 performance here.

The bottom line: Over time, the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.

Jeff Augen, a successful options trader and author of six books, agrees:

"There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. Unfortunately, there is no reliable method for predicting such an event. The opposite case is much more common - pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.