# An analysis of trading earnings releases using options

Historically, earnings announcements have played a prominent role in moving stocks. As a result, they represent the greatest known unknown in the world of investing. While projections and expectations are effective tools in modeling the direction and magnitude of equity plays, the world of options opens a new realm of opportunities based on trading volatility. After all, implied volatility (IV) scales with the unknown, so knowing when to capitalize on mispriced options can yield some great returns.

# Goals

• Why trade options around earnings?
• How are earnings options priced?
• How do we compare returns of long and short strategies?
• How important is option liquidity?
• What is implied volatility crush (IV crush)?
• What is earnings IV crush?
• How much does IV crush after earnings?
• Can we predict the earnings IV crush?
• Can we infer anything from the volatility surface?
• Can we still lose by selling overpriced IV?
• How can we hedge against directional moves?
• How do calendar trades hedge out directional risk?
• How can we employ calendar trades to capitalize on IV crush?
• How does this analysis hold up across the broader market?

# Why trade options around earnings?

Implied volatility correlates with the demand for buying and selling options. Given the uncertainty around earnings announcements, traders often turn to buying calls and puts in order to speculate and/or insure their positions going into earnings. The market generally has a bias for buying—as opposed to selling—options for two reasons:

1. Speculators are looking to place leveraged trades with capped downsides, so buying calls or puts provides them with the defined risk/reward potential that efficiently express their views.
2. Those looking for insurance are usually hedging against equity or option positions that need to scale with the size of a potential move. As a result, they need as much option upside as they can get in order to cover the scenarios they’re hedging against.

# How are earnings options priced?

This buy-side demand results in market makers ending up with books that are net short both calls and puts. This drives up the price of options, resulting in increasing IV until it finds an equilibrium relative to the overall market’s expected move. As the earnings date approaches, the at-the-money (ATM) IV for the nearest-term options is the most accurate proxy for the market’s expected post-earnings move.

Another way to look at the expected move is to price an ATM straddle made up by pairing the ATM call and put. The expectation is that this straddle should break even, so the combined premium is the implied move the market expects after the earnings announcement. If IV were too low, then there would be more buying pressure to drive the IV up. If it were too high, selling pressure would drive it down.

A side effect of this pricing means that the ATM call and put, which should trade around the same price, are available at roughly half the price of the expected move. If an investor correctly bets on the stock moving up the size of the implied move, having bought the call should have doubled their investment. In this same scenario, anyone long puts would see their value approach zero. Since the gains on the puts would offset the costs for the calls, a market maker with a balanced book would break even.

Consider the earnings moves for Microsoft ($MSFT) from 2016 through early 2022. Note that this series of earnings will be used extensively throughout this analysis because$MSFT is a large company with strong option liquidity. They also had a wide range of earnings results relative to post-earnings movements and different IV environments.

Actual Change represents the realized post-earnings move in the stock after one day. Notice how the size and direction of these moves are relatively unpredictable. Over the course of 25 earnings, the range of moves is from down over 7% to up over 6% with no obvious patterns. They did, however, average over a 1% gain overall.

Absolute Change is the absolute value of the change. This stock averaged a nearly 3% move one way or the other after the earnings releases in scope.

30d IV is the 30-day IV for MSFT immediately preceding the earnings announcement. Note that this is an annualized rate based on the option IVs expiring near 30 days out.

Periodic IV is the single day IV derived from the 30d IV. Think of this as the 30d IV “uncompounded” from its annualized rate to a single day.

Expected Move is the breakeven move implied by the option prices (double the periodic IV).

Error is the difference between the absolute change and the ATM expected move. The more green, the more the magnitude of the actual move exceeded the expected move.

Like the overall change numbers, the differences between the expected move and the actual move are unpredictable. However, the average turned out to be almost exactly on target with a mean error of just -0.05%. This negligible error indicates that—in aggregate—options have been priced nearly to perfection. So is there any opportunity here?

Over the term in focus, Microsoft rose an average of 1.11% the day after announcing earnings results. This would indicate that there might be some opportunity to trade directionally using options from the same term.

Here’s what the standard ATM option trades would have returned if each position were opened using the pre-announcement closing prices and closed using the post-announcement closing prices. The data below assumes market pricing such that all buys executed at the ask and all sells executed at the bid.

Unsurprisingly, bullish trades did better when the underlying price rose and fared worse when it dropped. However, it’s important to note that of the 17 times the stock rose after earnings, the ATM long call only appreciated in value 10 times. While some of this could be attributed to liquidity costs, the substantial difference of the average 1.11% return on the stock relative to the -5.66% return on long calls indicates that there’s much more at play. At the same time, selling puts instead of buying calls turned out to be a much more effective long strategy as it was profitable 21 times—including 4 times when the stock itself dropped—for an average return of 4.23%. Note that the short trades use the appropriate naked short margin requirement as the investment basis for each return.

# How do we compare returns of long and short strategies?

While it may be tempting to compare inverse long and short trade returns, it’s not as easy as it seems. All of the trades in use here are naked trades in that they’re all uncovered. While the term “naked” is most often associated with uncovered short positions, it also applies to long positions that don’t have corresponding short positions, especially for our purposes.

Comparing the returns on naked trades is complicated because they’re missing key data for practical purposes. Naked long positions have an unlimited maximum return for all practical purposes. While this isn’t technically true for long put positions, it effectively applies here as there’s no feasible value to use for its maximum return as the underlying is not expected to actually go to zero immediately following the earnings release. Without a maximum potential profit value, you can’t calculate how effectively the trade capitalized on the total opportunity like you could with a defined return trade.

The situation for short trades is similar in that while they both have well-defined maximum potential profits, they don’t have a practical cost basis. Like the issue with long puts above, the underlying cannot be expected to go to zero during our timeframe, so using the strike as an investment basis won’t offer useful results. Instead, short calls and puts use their naked margin requirement as the investment basis. The short straddle uses the greater margin requirement of the call and put legs. As a result, the maximum possible rate of return is the net profit relative to the margin requirement. In the cases where the corresponding puts or calls went to zero after earnings, the trade fully capitalized on the opportunity, but never reaches even 15% due to the high margin requirement used as the investment basis.

Given all of the above, the practical guidance is to use the total averages to evaluate how each strategy performed in aggregate over the course of the analyzed term. It’s not a perfect solution since each short trade strategy doesn’t have the same maximum potential return each time, but it’s good enough to understand the relative performance of each overall strategy.

# How important is option liquidity?

As mentioned earlier, liquidity is a key factor when considering options trades. In the options world, liquidity describes how easy it to enter and exit positions that express precise views. There are a lot of factors that come into play, including the number of option terms, the width of strikes available, typical volume, and open interest. However, the most important factor for the earnings trades we’ll cover here is the bid/ask spread. The wider it is, the more expensive it can be to enter and exit a given position because you’ll need to take a hit on the liquidity premium. For example, an option with the spread 0.95/1.05 may have a fair value of 1.00, but the spread could cost you 5% each time you trade it if you want immediate fills.

In order to minimize the impact of liquidity on our analysis, we’ll use midpoint pricing moving forward. This isn’t an ideal approach because it gives an unrealistic expectation as to the net returns, and it usually implies better returns that you’d probably get. However, our focus here is on the relative returns of trades to each other, so the absolute numbers aren’t as important.

*Note that the EOD midpoint pricing for the Jan 2016 trades indicated the long calendar straddle could be opened for $0.01 due to an infeasibly high put ask at the near expiration. To account for this, trades using that option were priced at the near put bid. This adjustment drastically lowered the long return and slightly raised the short return. The long calendar straddle strategy was profitable 14 of the 25 earnings periods analyzed here for an impressive average return of nearly 33%. In fairness, this is using midpoint pricing, which is probably too optimistic. However, it gives a more realistic view of option pricing than the EOD bid/ask spread leading into earnings. It’s also important to recognize that the average long calendar straddle had an opening cost of just 0.78% of the underlying stock price. In other words, if the stock were trading at$100, the typical long calendar straddle at close before the earnings announcement was just $0.78/share. Trade profitability was clearly dependent on the magnitude of the underlying move relative to its expected move. On average, they were virtually the same at 2.91% vs. the expected 2.97. As a result, the strategy was profitable 11 of the 13 times the actual move was less than the expected move. There are a variety of reasons why those trades could have lost money in their respective scenarios that include issues like lower IV crush than expected, poor option liquidity, or earnings IV richness. Another important detail here is that the trade was profitable 3 of the 12 times the actual move exceeded the expected move. This was likely due to higher IV crush, better option liquidity, or more favorable earnings IV richness. This also explains how the trades still retained a fair amount of value even when the actual move drastically exceeded the expected move. ## A note about calendar strangles A close cousin to the calendar straddle is the calendar strangle. It’s the same conceptually, except that the call and put strikes are both OTM instead of ATM. While calendar strangles also profit from IV crush, our analysis found them to be less successful overall due to substantially higher time value lost in the long strangle component. However, if there is strong evidence that the underlying will make an outsized move in either direction, picking the correct strikes for a calendar strangle should outperform the calendar straddle. # How does this analysis hold up across the broader market? The data used so far in this analysis was limited to the 25 earnings releases for$MSFT from 2016 through early 2022. To consider how these results hold up across the broader market, we expanded the analysis to include all optionable US equities. The only refinement applied was to cull out stock that didn’t have strong option liquidity in order to focus on realistic market opportunities and minimize the impact of midpoint pricing.

To perform this filter, we only used earnings releases for stock that had a Quantcha Liquidity Rating of 4 or higher on the last trading day before the release. This rating evaluates the option liquidity for stocks on a daily basis and includes factors such as the number of option terms available, distance between option strikes, volumes, open interests, and the bid/ask spreads.

The final result produced 1,097 earnings releases across 434 stocks between 2016 and the beginning of 2022. The qualifying releases skewed toward the more heavily traded stocks and toward more recent releases, although quite a few smaller stocks also made the cut if their options were heavily traded. About 15% of the releases were for stocks that only had one qualifying release make the cut.

Among these releases, the average 1-day return for the underlying was around 50bps, although the average magnitude of the change was nearly 5%. Option volatility was slightly underpriced across these releases with an error of 37bps, which likely indicates that there was often significant interest in selling IV from the market.

Given the market’s support for selling IV, earnings IV was much less exaggerated going into announcements. As a result of these tempered numbers, earnings IV only crushed to 60% on average. However, that doesn’t mean that there wasn’t real opportunity.

The first six trades above reference trading the ATM earnings options. The calendar trades combine the earnings straddles with the inverse position at the next expiration.

Unlike the $MSFT trades, it appears that the better way to have traded bullish returns was via long calls (as opposed to short puts). This likely indicates that IV was underpriced going into earnings when the underlying ultimately enjoyed a bullish move. On the other hand, the more effective bearish trade was to sell calls, which suggests that IV tended to be exaggerated in cases where the underlying ultimately dropped after earnings. Obviously, these sorts of conclusions are easy to presume in hindsight, so this is more speculation than actionable insight. The most striking data point, however, is the outsized rate of return for the long calendar straddle. While not quite the 33% seen for$MSFT earnings, it still averaged nearly 13%. This suggests that the opportunity to profit off of earnings IV crush may be consistently available even when earnings IV. The trade was profitable around 53% of the time with an average return of 66% when profitable.

# Key conclusions

This report highlights some of the opportunities that exist when using options to trade earnings results. Here are some of the key conclusions we’ve come to in the process of researching it.

Earnings IV crush is real and has been the most substantial and reliable opportunity lately. Strategies focused on selling IV outperformed other types of trades most of the time, regardless of the ultimate move of the underlying. Data like IV across different terms and Quantcha’s Earnings Crush Rate can help derive a richness metric to identify special opportunities on a case-by-case basis.

Naked directional trades are generally not worth the risk. Most of the earnings releases in scope occurred during a bull run, but bullish option trades didn’t generally pay well during the period. This doesn’t invalidate the notion of using directional option strategies when expressing a directional view, but simply buying calls during a bull run earnings period shouldn’t be assumed to outpace an underlying position. Even when you’re right about direction, you’ll still need to be right about timing and magnitude to see a profit.

Option liquidity is an extremely important factor. Although option liquidity tends to be highest for stocks leading into their earnings releases, it’s not necessarily a guarantee of great pricing. As the strike moves further from the money, there will be fewer market participants willing to take the other side of your trade, so consider data like the Quantcha Liquidity Rating to locate opportunities worth pursuing.

# Data used in this research

Much of the volatility data used for this research came from Quantcha’s US Equity Historical & Option Implied Volatilities database available through NASDAQ. It’s updated daily and includes over 60 daily volatility indicators for historical and implied volatilities across terms ranging from 10-day to 1080-day (3-year), as well as skew steepness measurements.

The Earnings Crush Rate and Liquidity Ratings used here came from Quantcha’s US Equity Option Ratings database available through NASDAQ. It’s also updated daily and includes key option-derived data points for earnings, option liquidity, and IV valuation ratings like IV Rank, IV Percentile, and Quantcha’s proprietary IV Rating.