Volatility and Trading Earnings
In our previous post about the option greeks, we touched on Vega, the option greek for volatility. In this post, we will take a deeper look at volatility, and show how you can use straddles to take advantage of volatility and earnings announcements.
Vega is the sensitivity of option prices to changes in the underlying security's volatility. Remember that vega is positive for both calls and puts, which means that higher volatility results in higher prices for both types of options. On the other hand, lower volatility decreases option prices.
There are two different types of volatility - historical volatility and implied volatility. Historical volatility is calculated based on price movement in the past, while implied volatility is an estimate that is inferred from a pricing model based on the current market price of an option. Vega is based on implied volatility. If implied volatility is higher than historical volatility, it could mean that the option is overpriced relative to past volatility. This is often the case leading up to earnings releases, since the market is pricing in a large move.
The high implied volatility before earnings releases can lead to a phenomenon known as IV crush. Before earnings, there is a lot of uncertainty; no one knows whether the stock will go up or down when earnings are released, and there is potential for a huge price move. This means that implied volatility is higher than usual leading up to an earnings release, resulting in options that are more expensive. After earnings are announced, the uncertainty regarding the announcement is gone, so implied volatility drops. This is what is meant by IV crush. When implied volatility drops suddenly, so do option prices. Because of this, you need to be careful trading long options around earnings. But luckily, stocks will often make big enough moves after earnings to more than make up for the IV crush.
A good options strategy to trade earnings releases is the straddle. To create a straddle, a trader simultaneously buys a call and a put with the same strike price and expiration date. Since this strategy involves a call and a put, it is directionally neutral; you can make a profit whether the underlying goes up or down.
To illustrate how a straddle works, we will look at our Straddle and Earnings Indicators on the chart below for Adobe (ADBE) as an example.
It's usually a good idea to use the at-the-money strike price to trade a straddle, in order to prevent a directional bias. In this case, the closest strike price is 392.50 (the horizontal dotted line). According to the label at the top, the next earnings release date is 6/11. I chose the closest expiration date after the earnings date, which in this case is the next day on 6/12. Options with the closest expiration date after earnings will move more than longer-term options.
If you went to the option chain and bought the 392.50 call and 392.50 put with the 6/12 expiration date, it would cost you a total of $18.13 (times 100 shares). In order to recover the cost of the straddle to break even, ADBE would need to move at least $18.13 in either direction. So the breakeven points for the straddle are 410.63 to the upside (392.50 + 18.13) and 374.37 to the downside (392.50 - 18.13). If ADBE moves past either of these points, you would make a profit. If the price stays between these points, the maximum amount you could lose is the straddle premium of $18.13. The indicator makes this process easy by automatically selecting the at-the-money strike price and calculating the cost of a straddle and the breakeven points.
In order to help you pick which stocks you want to trade for earnings announcements, this tool also gives you information about implied volatility, such as the current IV, IV rank, IV percentile, and the average IV crush after each earnings release. In addition, it tells you how the stock reacted to the previous four earnings announcements, so you can see how volatile the stock has been historically on the day following the announcements.
As you can see, ADBE is a good candidate for a straddle trade before this earnings release. It moves an average of 7.15% after an announcement, but implied volatility is relatively low, so the market is only pricing in a move of 4.61%. This mismatch creates the potential for profit if the stock moves more than the market is expecting. The risk is that the stock doesn't move very much after earnings are released, in which case the IV crush would destroy any chance of a profit.
Straddles can also be sold short by selling a call and a put at the same time. Short straddles are a good choice if you believe the underlying stock won't move as much as the market is expecting (i.e. you think implied volatility is too high). By shorting a straddle, the straddle premium you collect would be your maximum potential profit. The benefit of a short straddle is that it takes advantage of IV crush. If implied volatility drops, the price of the call and the put both decrease, which is what you want if you have a short straddle position. In addition, a short straddle takes advantage of the time decay on both options. However, if the stock moves outside either of the breakeven points, you could experience a very large loss.
For more info about the straddle and earnings tools shown in the example above, or to download them, click here.