Over the next 2 weeks we will see many of the big market moving stocks release their quarterly earnings numbers.
These releases can cause large market moves overnight in the stock price. While this can provide an incredible opportunity for big profits if you pick the directional move correctly, it also comes with higher risk.
We aren’t opposed to trading around earnings, but when doing so we want to make sure we are using the best options strategy that will give us the best odds of making money. We will walk through a few scenarios below to show how you can use different options strategies to make money from trading around earnings.
If you are going to trade options on individual stocks over the next few weeks, it is important to know when those stocks are releasing their earnings numbers. You don’t want to get blindsided by an earnings event that you didn’t know was coming.
We like to use https://www.earningswhispers.com as a tool to look up the specific earnings dates and times for each stock on our list.
How To Trade Options Around An Earnings Release
The easiest way to make a directional bet around an earnings release is to buy a call option to be bullish or buy a put option to be bearish.
The trouble with that approach is there are more factors that go into the performance of those trades than the directional move in the stock.
We are going to walk through an example using Tesla (Symbol: TSLA) to show how we approach an earnings-related trade. TSLA has earnings out Monday 7/26 after the market closes.
Options Pricing Model
Before we get into the specifics on TSLA, let’s review the options pricing model to highlight the factors that will impact the performance of an options trade.
There are 6 different inputs in the pricing model of an option:
-Time to expiration
The two inputs that we need to be most concerned with for an earnings trade are the Stock Price and Volatility as the potential for big moves due to these 2 factors is extreme.
Let’s take a look at TSLA using a few potential earnings trades to highlight the pros and cons of using a long option and a short option approach.
Pros And Cons Of Long/Short Options Approach
TSLA has been stuck in a choppy pattern over the last month with price stuck in a range between $640-$690. We also know that TSLA doesn’t like to stay quiet for long, especially around an earnings release. This could leave us with an interesting opportunity to benefit from the stock breaking out of this range around earnings. So how do we trade it?
We will talk about taking a pure directional trade first.
If you want to put on a directional trade on TSLA expecting a big reaction higher or lower due to the earnings release you could buy a long call or long put option.
The problem with buying long options going into earnings on any stock, let alone an expensive name like TSLA, is the expected big move due to the earnings numbers.
Trade Option #1:
- Buy the July 30 – 670 call option
- Bullish Trade
- Cost: $19.60 or $1960 per contract
- Max Risk: $1960
- Max Profit: Unlimited
Trade Option #2:
- Buy the July 30 660 put option
- Bearish Trade
- Cost: $18.70 or $1870 per contract
- Max Risk: $1870
- Max Profit: Unlimited
Market makers are pricing in that uncertainty which is making the options expensive. With earnings out after the close this afternoon, market makers are pricing in a $39.32 move higher or lower after the earnings come out. We can find this expected move on the Thinkorswim trade page.
The expected move won’t tell you which direction the stock will move in, but it will tell you the expected range higher or lower. With this expected move priced into the options you need a big move to happen to justify the expensive price of the options and make money from the trade.
Not only do we need a big directional move to take place in the stock price, we need it to be big enough to offset the volatility dropping after the earnings uncertainty is out of the way.
Market makers will juice the implied volatility being used to price the options higher to price in the unknown reaction in the stock price. As a result, the options will be expensive going into the event.
Once the earnings are known, they will suck the volatility back out of the options which will cause them to lose money.
Not only do you need the stock to move higher or lower in a big way with a long call or put strategy around earnings, it needs to be big enough to offset the volatility moving lower after the event.
- The good news is the potential is there for a big return around earnings if you get the big directional move in the stock price in your favour.
- The bad news is in order to make money with these strategies you need a lot to go right in your favour.
Is there anything else we can do to participate in TSLA earnings with better odds of success?
We just discussed how the market makers are pricing in a big directional move into the TSLA options. They are pricing in a $39.32 move while also spiking the volatility levels higher as well. Knowing this, what can we do to take advantage of these features?
The third trade that we will take a look at is selling a credit spread.
For this example, we are going to take a look at selling a call spread on TSLA. The stock has had a nice move higher going back to late May as price has moved from $550 up to $700 in early July. As a result, we don’t mind leaning bearish on this position. Selling a call spread allows us to put a bearish trade that will tie up far less capital and give us multiple ways of making money on trade.
Trade Option #3:
- Sell the July 30 687.5/690 call spread. We are selling the 687.5 call and buying the 690 call at the same time.
- Neutral to bearish trade
- Trade Price: $.82 or $82 per spread
- Max Profit: $82 per spread
- Max Risk: $168 per spread
By selling the call spread, we are able to lower the cost of the trade from over $1900 to buy the long put option down to $168 for selling the call spread. Not only are we able to lower the cost of the trade, but we will have multiple ways of making money on trade.
We make money on this spread as long as the TSLA stock price stays below $688.32. If the stock moves higher, lower, or sideways that is fine as long as it stays below $688.32.
We can also make money from volatility decreasing which is something we know will happen after earnings. Finally, we also can make money from the time decay adding up.
Instead of having one way of making money when buying the long call or put, we will have 5 ways of making money with the credit spread. The trade off is we will also have far less profit potential.
The most money we can make on the trade is the $82 that we are selling the spread for.
If we are dead wrong on the directional move in TSLA stock and the move is higher instead of lower the most we can lose on the trade is $168 per spread. This is far less than the $1900+ max loss that could happen if you are on the wrong side of the move with a long call or long put.
Which Options Trade Is Best?
In most cases, when trading around earnings I prefer to sell the credit spreads. While they won’t produce the big winners that a long call or long put can, they will drastically reduce the cost of the trades and provide multiple ways of making money which will give us a more forgiving trade.
Whether you are buying a call or put option going into earnings or selling a credit spread, the key is to keep the risk small. Earnings plays in most cases will be all or nothing.
The trade will either be a nice winner or full loser overnight.
Don’t get caught going for the home run trades on every earnings trade. Going for the singles and doubles with the higher probability credit spreads can add up to a really nice return with far better odds in your favor.
We have traders that never take earnings trades and that is just fine. I will trade through earnings but like to keep the risk around 50% of my normal position size. This will allow me to stay active through earnings without large risk that can lead to big draw downs in the account.
Manage your risk through earnings and focus on strategies that will give you multiple ways of making money can produce a nice additional way of growing your account.
We will be back tomorrow to take a look at the outcomes of the 3 trades above.