Ready to get started trading earnings with options? Check out Quantcha’s top 10 features for you<\/a>!<\/p>\n\n\n\n Our goals here are to use data to help answer some of the\nfrequently asked questions about trading earnings with options, including:<\/p>\n\n\n\n Implied volatility correlates with the demand for buying and\nselling options. Given the uncertainty around earnings announcements, traders\noften turn to buying calls and puts in order to speculate and\/or insure their\npositions going into earnings. The market generally has a bias for buying\u2014as\nopposed to selling\u2014options for two reasons:<\/p>\n\n\n\n This buy-side demand results in market makers ending up with\nbooks that are net short both calls and puts. This drives up the price of\noptions, resulting in increasing IV until it finds an equilibrium relative to\nthe overall market\u2019s expected move. As the earnings date approaches, the\nat-the-money (ATM) IV for the nearest-term options is the most accurate proxy\nfor the market\u2019s expected post-earnings move.<\/p>\n\n\n\n Another way to look at the expected move is to price an ATM\nstraddle made up by pairing the ATM call and put. The expectation is that this straddle\nshould break even, so the combined premium is the implied move the market\nexpects after the earnings announcement. If IV were too low, then there would\nbe more buying pressure to drive the IV up. If it were too high, selling\npressure would drive it down.<\/p>\n\n\n\n A side effect of this pricing means that the ATM call and\nput, which should trade around the same price, are available at roughly half\nthe price of the expected move. If an investor correctly bets on the stock\nmoving up the size of the implied move, having bought the call should have doubled\ntheir investment. In this same scenario, anyone long puts would see their value\napproach zero. Since the gains on the puts would offset the costs for the\ncalls, a market maker with a balanced book would break even.<\/p>\n\n\n\n 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.<\/p>\n\n\n\n Actual Change<\/strong> represents the realized post-earnings\nmove in the stock after one day. Notice how the size and direction of these\nmoves are relatively unpredictable. Over the course of 25 earnings, the range\nof moves is from down over 7% to up over 6% with no obvious patterns. They did,\nhowever, average over a 1% gain overall.<\/p>\n\n\n\n Absolute Change<\/strong> is the absolute value of the change.\nThis stock averaged a nearly 3% move one way or the other after the earnings\nreleases in scope.<\/p>\n\n\n\n 30d IV<\/strong> is the 30-day IV for MSFT immediately\npreceding the earnings announcement. Note that this is an annualized rate based\non the option IVs expiring near 30 days out.<\/p>\n\n\n\n Periodic IV<\/strong> is the single day IV derived from the 30d\nIV. Think of this as the 30d IV \u201cuncompounded\u201d from its annualized rate to a\nsingle day.<\/p>\n\n\n\n Expected Move<\/strong> is the breakeven move implied by the\noption prices (double the periodic IV).<\/p>\n\n\n\n Error<\/strong> is the difference between the absolute change\nand the ATM expected move. The more green, the more the magnitude of the actual\nmove exceeded the expected move.<\/p>\n\n\n\n Like the overall change numbers, the differences between the\nexpected move and the actual move are unpredictable. However, the average\nturned out to be almost exactly on target with a mean error of just -0.05%. This\nnegligible error indicates that\u2014in aggregate\u2014options have been priced nearly to\nperfection. So is there any opportunity here?<\/p>\n\n\n\n Over the term in focus, Microsoft rose an average of 1.11% the\nday after announcing earnings results. This would indicate that there might be\nsome opportunity to trade directionally using options from the same term.<\/p>\n\n\n\n Here\u2019s 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.<\/p>\n\n\n\n Unsurprisingly, bullish trades did better when the\nunderlying price rose and fared worse when it dropped. However, it\u2019s important\nto note that of the 17 times the stock rose after earnings, the ATM long call\nonly appreciated in value 10 times. While some of this could be attributed to\nliquidity costs, the substantial difference of the average 1.11% return on the\nstock relative to the -5.66% return on long calls indicates that there\u2019s much\nmore at play. At the same time, selling puts instead of buying calls turned out\nto be a much more effective long strategy as it was profitable 21\ntimes\u2014including 4 times when the stock itself dropped\u2014for an average return of\n4.23%. Note that the short trades use the appropriate naked short margin\nrequirement as the investment basis for each return.<\/p>\n\n\n\n While it may be tempting to compare inverse long and short\ntrade returns, it\u2019s not as easy as it seems. All of the trades in use here are naked<\/strong>\ntrades in that they\u2019re all uncovered. While the term \u201cnaked\u201d is most often\nassociated with uncovered short positions, it also applies to long positions\nthat don\u2019t have corresponding short positions, especially for our purposes.<\/p>\n\n\n\n Comparing the returns on naked trades is complicated because\nthey\u2019re missing key data for practical purposes. Naked long positions have an\nunlimited maximum return for all practical purposes. While this isn\u2019t\ntechnically true for long put positions, it effectively applies here as there\u2019s\nno feasible value to use for its maximum return as the underlying is not\nexpected to actually go to zero immediately following the earnings release. Without\na maximum potential profit value, you can\u2019t calculate how effectively the trade\ncapitalized on the total opportunity like you could with a defined return\ntrade.<\/p>\n\n\n\n The situation for short trades is similar in that while they\nboth have well-defined maximum potential profits, they don\u2019t have a practical\ncost basis. Like the issue with long puts above, the underlying cannot be\nexpected to go to zero during our timeframe, so using the strike as an\ninvestment basis won\u2019t offer useful results. Instead, short calls and puts use\ntheir naked margin requirement as the investment basis. The short straddle uses\nthe greater margin requirement of the call and put legs. As a result, the\nmaximum possible rate of return is the net profit relative to the margin\nrequirement. In the cases where the corresponding puts or calls went to zero\nafter earnings, the trade fully capitalized on the opportunity, but never\nreaches even 15% due to the high margin requirement used as the investment\nbasis.<\/p>\n\n\n\n Given all of the above, the practical guidance is to use the\ntotal averages to evaluate how each strategy performed in aggregate over the\ncourse of the analyzed term. It\u2019s not a perfect solution since each short trade\nstrategy doesn\u2019t have the same maximum potential return each time, but it\u2019s\ngood enough to understand the relative performance of each overall strategy.<\/p>\n\n\n\n As mentioned earlier, liquidity is a key factor when\nconsidering options trades. In the options world, liquidity describes how easy\nit to enter and exit positions that express precise views. There are a lot of\nfactors that come into play, including the number of option terms, the width of\nstrikes available, typical volume, and open interest. However, the most\nimportant factor for the earnings trades we\u2019ll cover here is the bid\/ask\nspread. The wider it is, the more expensive it can be to enter and exit a given\nposition because you\u2019ll need to take a hit on the liquidity premium. For\nexample, an option with the spread 0.95\/1.05 may have a fair value of 1.00, but\nthe spread could cost you 5% each time you trade it if you want immediate fills.<\/p>\n\n\n\n In order to minimize the impact of liquidity on our\nanalysis, we\u2019ll use midpoint pricing moving forward. This isn\u2019t an ideal\napproach because it gives an unrealistic expectation as to the net returns, and\nit usually implies better returns that you\u2019d probably get. However, our focus\nhere is on the relative returns of trades to each other, so the absolute\nnumbers aren\u2019t as important.<\/p>\n\n\n\n Also, during market hours, near-term ATM options for $MSFT\ngenerally trade with penny spreads such that the 1.00 option from earlier would\nbe priced 0.99\/1.00 or so. However, our analysis uses end-of-day (EOD) market\nprices, so the spreads will be a bit wider. Using the midpoint is probably a better\napproximation of the kinds of returns that would have been seen during peak\nmarket hours.<\/p>\n\n\n\n Now let\u2019s take a look at the returns for the trades above using midpoint pricing.<\/p>\n\n\n\n You might have noticed that the average returns for both\nlong and short calls were positive. This is a peculiar side effect of the way\nnaked short returns are calculated as described earlier. Obviously the net\ngains from the long call strategy exactly equal the net losses for the short\ncall strategy. But since they use different methodologies for calculating the\ninvestment bases their returns are derived from, the returns don\u2019t line up\nperfectly. While the short call strategy would have produced a net loss had it\nbeen equally weighted across terms, the nature of averaging trade returns that\naren\u2019t exactly equal produced this slightly misleading result.<\/p>\n\n\n\n While all of the returns are understandably better than\nthose shown earlier, they still tell the same general story about how the short\ndirectional or straddle trade outperforms its long counterpart (selling puts\nvs. buying calls). Why exactly does selling options outperform? The answer is\nIV crush.<\/p>\n\n\n\n Implied volatility is the measure of how uncertain the\noutcome of a given option will be leading into its expiration. It can change\nover the course of its lifetime as certainty increases or decreases due to\nvirtually any reason. When certainty increases drastically\u2014such as when an\nearnings report is disclosed\u2014the market has an opportunity to reset\nexpectations for the underlying with greater confidence. This increased\nconfidence means that there is less risk due to unknowns, so implied volatility\ndrops almost immediately.<\/p>\n\n\n\n This drop is known as IV crush<\/strong> and is expressed as the percentage of IV retained by an option after the event occurs. For example, an option with an IV of 50% ahead of earnings may drop to 35% after the announcement. In this scenario, the crush rate is calculated as $latex \\frac{35\\%}{50\\%}=70\\%$.<\/p>\n\n\n\n IV crush almost always happens immediately after each\nearnings announcement and is usually in the 50-90% range for the 30-day IV. Of\ncourse, this earnings IV crush<\/strong> is subject to the circumstances of the\nmarket and underlying. Investors new to options often bemoan the impact of IV\ncrush, especially after earnings.<\/p>\n\n\n\n The story is always the same. An investor has a directional\nview, so they buy calls or puts to express it. They turn out to be right about\nthe direction but are shocked to discover that the options aren\u2019t worth nearly\nwhat they expected them to be worth when the market opens. This is because the\nuncertainty was cleared up in the earnings release, leaving a much more\npredictable range of outcomes for the underlying. This predictability means\nthat IV gets crushed and many options may end up only being worth their\nintrinsic value. If the underlying didn\u2019t quite move enough to make up for the\ncrush, then the investor could end up being correct and still lose money. It\u2019s\nbecome a rite of passage for many on forums like Reddit. It\u2019s also the explanation\nas to why short option strategies outperformed long option strategies during\nthe earnings periods discussed earlier.<\/p>\n\n\n\n This isn\u2019t necessarily an argument against making\ndirectional earnings plays with options. Instead, it\u2019s a reminder that with options\nyou need to not just be right about direction, but also magnitude and timing.\nIn the meantime, the clock is ticking away and the time value for long options\n(measured as theta<\/strong>) keeps slipping away.<\/p>\n\n\n\n Here are the actual crush numbers for IV around recent\nMicrosoft earnings.<\/p>\n\n\n\n IV Before<\/strong> is the IV for the nearest option term on\nthe last pre-earnings trading day. The nearest IV expiring after earnings is\nalso referred to as the earnings IV<\/strong>. Note that this IV is derived purely\nfrom the options at this term, unlike the 30-day IV, which is usually blended\nfrom options straddling the 30-day horizon.<\/p>\n\n\n\n Final IV<\/strong> is the earnings IV on the first\npost-earnings trading day.<\/p>\n\n\n\n Actual Crush<\/strong> is the crush rate observed by dividing\nthe post-earnings IV into the pre-earnings IV. Earnings IV crush is expected to\nbe substantially more impactful than the crush applied to the 30-day IV, hence\nthe lower rate of IV retained.<\/p>\n\n\n\n As IV is almost always elevated going into earnings, it can\nbe expected to drop after the uncertainty is cleared up. However, in some cases\nthe earnings results may introduce concerns about the underlying, so there are\noccasionally increases in IV as the market shifts from earnings uncertainty to\nuncertainty around something disclosed in the earnings release. As a result,\nthe highest crush rates (the times when IV contracted the least) usually\ncoincide with disappointing earnings where the stock drops afterwards.<\/p>\n\n\n\n Historically, the market has used the long-term IV as a\npredictor for the level IV will settle into after an earnings report. While\nshort-term IVs are heavily correlated with the next earnings release, long-term\nIVs look out over a period of quarters\u2014or even years\u2014during which there will be\nmany events to consider. As a result, they don\u2019t tend to elevate much as\nnear-term announcements approach.<\/p>\n\n\n\n Here\u2019s a comparison of how effective long-term IV has been\nat predicting the IV crush for near-term IV.<\/p>\n\n\n\n Long Term IV <\/strong>is the IV for the farthest available\noption term on the last pre-earnings trading day.<\/p>\n\n\n\n Implied Crush<\/strong> is the crush rate implied by dividing\nthe farthest IV into the nearest IV before earnings.<\/p>\n\n\n\n Actual Crush<\/strong> is the observed crush after the earnings\nannouncement.<\/p>\n\n\n\n Actual vs. Implied<\/strong> is the actual crush less the\nimplied crush. In almost every case, the long-term IV underestimates the size\nof the crush. This is partly because the long-term IV includes many events over\nthe course of years, whereas the remaining earnings IV is often just a few\nhours or days with little news expected.<\/p>\n\n\n\n Beside the long-term IV, options investors also look at the\nvolatility surface to better understand the perceived risk around earnings. The\nvolatility surface<\/strong> is simply the mapping of all option volatilities\nacross all terms in a single view. Whereas the IVs for a given term can be\neasily mapped on a 2D surface to provide the volatility skew<\/strong>, extending\nand connecting multiple skews across different terms creates a 3D model known\nas the volatility surface. The peaks and valleys of the surface are often used to\nidentify where the market is pricing options more or less than might be\nexpected relative to nearby strikes or terms.<\/p>\n\n\n\n While the surface can\u2019t tell you what IV will crush to after\nearnings, it can tell you what the market is pricing<\/em> options to crush\nto. After all, if there are prevailing prices for the options at the same\nstrike across different terms, there must be a price at which a calendar trade\nbreaks even.<\/p>\n\n\n\n For example, consider two ATM calls trading at the same\nstrike one week apart and both expiring after the next earnings call. If you\nsell the front week and buy the back week, it\u2019s possible to determine various scenarios\nat which the trade will break even based on experimenting with different\nunderlying prices and IV after the earnings announcement. Since both options\nhave the same strike, underlying price changes (delta) will cancel out, so the\nweek one call will lose value faster than the week two option\u2014unless the\nchanges in IV are inconsistent. Identifying exactly what those IVs are yields\nthe earnings IV crush rate implied by the market.<\/p>\n\n\n\n Earnings Crush Rate<\/strong> is Quantcha\u2019s proprietary\nmeasurement of the crush rate being priced by the market for the first ATM\noptions expiring after earnings. The higher the rating, the more IV the ATM\noptions are expected to retain after the announcement. However, like the other\ncrush rates, these are measured relative to the options that are ATM at the\ntime, which may be different options depending on how much the underlying price\nmoves.<\/p>\n\n\n\n Actual vs Crush Rate<\/strong> is the actual crush rate less\nthe Earnings Crush Rate. The lower this rate, the more the ATM IV crushed\nbeyond the market pricing.<\/p>\n\n\n\n It’s important to understand that the Earnings Crush Rate\nisn\u2019t a guarantee of what the rate will crush to. Instead, it\u2019s the inference\nof what the market is pricing it to crush to after earnings based on the\nvolatility surface. The higher this rate is, the less the market is pricing\nearnings IV to crush by. However, to better gauge the magnitude of the premium\nit\u2019s useful to compare the rate\u2014or at least the IV the rate implies\u2014to estimate\nthe size of the opportunity. Since we can usually expect the earnings IV to\ncrush below the long-term IV, it\u2019s a good candidate for comparison. By\nsubtracting the long-term IV from the crush-implied IV, we can produce a richness<\/strong>\nrating.<\/p>\n\n\n\n Crush Implied IV<\/strong> is the pre-earnings IV multiplied by the Earnings Crush Rate. This is what the post-announcements earnings IV is priced to drop to.<\/p>\n\n\n\n Richness<\/strong> is the crush-implied IV less the long-term\nIV. The higher the richness, the more premium the earnings options are\ndemanding relative to the expected IV indicated over the long term. If the\nearnings IV ultimately crushes to (or below) the long-term IV, which is usually\ndoes, then the pre-earnings IV will have been overpriced relative to the rest\nof the surface.<\/p>\n\n\n\n In short, yes. The nature of IV is that it represents the\nrisk of a move of a certain magnitude in the underlying asset. When we\ndetermine that IV is overpriced, what we\u2019re really saying is that the\nprobability of a large enough move to justify the breakeven price is not worth\nthe cost of the options. In many cases this isn\u2019t really feasible by using\noption prices alone. After all, the risk is measured from IV derived from\noption prices, which are calculated based on the perceived risk. It\u2019s a\nself-regulating loop. If the market thinks that IV is overvalued, then it gets\nsold. This action drives down option prices, in turn driving down IV until it\nreaches equilibrium with the market consensus.<\/p>\n\n\n\n However, none of this means that the probability of an\noutsized move is out of the question. It\u2019s always possible for an overpriced\noption to appreciate in value, so the notion of blindly selling options to\ncapitalize on IV crush isn\u2019t always going to work. However, the data from\nearlier indicates that selling naked earnings straddles for MSFT would have\nproduced a net profit averaging 5% over the past 25 earnings releases, so the\nnumbers appear to be in favor. The only time the trades lost big were when the\nunderlying move substantially beyond the move implied by IV.<\/p>\n\n\n\n The basic strategies covered so far have been effective in\nillustrating the nature of earnings trades using some simple option approaches.\nHowever, despite the fact that the underlying moved up following most of the\nearnings, it\u2019s clear that the real winner has usually been selling IV against\nthe impending crush. However, there were enough outsized moves to blow naked\nshorts out of the water often enough to substantially dampen long-term average\nreturns.<\/p>\n\n\n\n So the new question becomes, how can we sell IV while simultaneously\nhedging against those outsized directional moves? Thanks to the versatility of\noptions, there are a lot of ways.<\/p>\n\n\n\n The most obvious answer is to hedge the short call and put\nby buying corresponding calls and puts. This caps your risk and provides a\ndefined potential return. <\/p>\n\n\n\n The downside of this trade relative to short straddle is\nthat the cost of the hedging options eats away at potential profit. Plus, since\nboth options are OTM, they\u2019re both entirely paying for time value and one will\nalmost surely end up worthless.<\/p>\n\n\n\n A similar strategy to the short straddle is the short\nstrangle. It provides a way to sell IV while partially hedging against an\noutsized move by sliding strikes farther out of the money (OTM). For example,\ninstead of selling ATM options where one side will definitely be in the money\nthe next day, you can sell a strangle that combines a short OTM call and a\nshort OTM put.<\/p>\n\n\n\n The farther the strikes are from the money, the more likely\nboth will still be OTM after the earnings move. The downside to this strategy\nis that the time value premium collected decreases rapidly as strikes get\nfarther from the money, so one big loss could wipe out profits from several\ncomplete wins.<\/p>\n\n\n\n If you combine the logic behind the short strangle and iron\nbutterfly strategies, you end up with the iron condor. It provides good hedging\nby widening the area for maximum profit while also capping risk.<\/p>\n\n\n\n However, these hedging compromises mean that not only are\nyou accepting less credit to open, but you\u2019re also paying for insurance. In\nthese cases, it\u2019s critical that the underlying not breach the short strikes as\nthe costs of managing iron condors around earnings can be very expensive unless\neverything comfortably expires on its own.<\/p>\n\n\n\n The strategies discussed in this section can help you\ncapitalize on profit from overpriced IV while hedging against an outsized move\nin the underlying. However, they all include their own directional risks. As a\nresult, they\u2019re not really \u201cshort IV\u201d strategies as much as they\u2019re \u201cundersized\nmove\u201d strategies. Despite having near-zero deltas and gammas, these strategies\ndon\u2019t do a great job of isolating the IV opportunity because their profits are\nentirely centered on the expectation that the underlying will move less than\nthe IV implies it will.<\/p>\n\n\n\n The concepts discussed during the IV crush section focused\non how the crush for earnings IV occurs within the context of the rest of the\nvolatility surface. In other words, capitalizing on the overpriced IV in the\nshortest-dated options can only really be directionally hedged with options\nexpiring on a later date or else they would be surrendering the IV advantage as\nall options for a given date are subject to the same elevated IV. Strategies\nmaking use of options expiring across different terms are known as calendar<\/strong>\ntrades.<\/p>\n\n\n\n Option prices can be broken down into two different\ncomponents: intrinsic and extrinsic.<\/p>\n\n\n\n Intrinsic<\/strong> value is based on how deep the options are\nin the money (ITM). In other words, this represents the value of immediate\nexercise. If a stock is trading at $110, all of its call options struck at 100\nhave $10 of intrinsic value per share, regardless of when they expire. All OTM\noptions have an intrinsic value of 0.<\/p>\n\n\n\n Extrinsic<\/strong> value is also known as time value<\/strong>\nand represents everything that gives the option value besides its intrinsic\nvalue. This value is based on a combination of the factors that drive\nuncertainty around whether or not the option will expire ITM. In other words,\noptions that are virtually guaranteed to expire in or out of the money will\nhave no extrinsic value. The highest extrinsic value is always for options ATM.<\/p>\n\n\n\n Simply put: $latex fair\\ option\\ value=intrinsic\\ value+extrinsic\\ value$<\/p>\n\n\n\n As a side note, there is a third value that comes into play\nwhen evaluating the fair option value relative to its price: liquidity cost<\/strong>.\nThe liquidity cost is the difference you pay or receive from the fair option\nvalue and is usually inferred from the bid\/ask spread. Since we\u2019re working with\nmidpoints here, the option price is considered the same as the fair option\nvalue.<\/p>\n\n\n\n Consider a trade where you are short one near-term call at\n100 and long another longer-term call at 100. Assume there are no underlying\ndividends to account for. As the underlying moves up or down, the intrinsic\nvalue of both options remains the same because they are struck at the same\nprice.<\/p>\n\n\n\n Although they have the same intrinsic value, the options likely\nhave slightly different deltas as the shorter-dated option is more sensitive to\nunderlying price movement. But that\u2019s not because its intrinsic value changes\nmore. It\u2019s because the likelihood of the option being ITM at expiration changes\nmore from underlying price movement. Longer-dated options provide more time for\nthe underlying to move, so their deltas will be lower. <\/p>\n\n\n\n Given that they have the same strike, the shorter-dated call\nwill also have a higher theta. This means that its time value will erode faster\nthan the time value of the longer-dated call as the ITM uncertainty drains\nfaster.<\/p>\n\n\n\n If the IV of the near-term call drops more than that of the\nlong-term call (as we expect from earnings IV crush), then we\u2019ll also see an\noutsized decrease in value there, as well. Since we\u2019re short the near-term call,\nthis will play to our advantage.<\/p>\n\n\n\n The most effective strategy for capitalizing on earnings IV\ncrush trades is the calendar straddle<\/strong>. Put simply, this strategy involves\nselling the ATM straddle for the overpriced term while buying that same\nstraddle for the underpriced term. When the long straddle is taken for the\nlater week, the strategy opens with a net debit and is the long calendar\nstraddle<\/strong>. Buying the near week and selling the far week produces a net\ncredit and is the short calendar straddle<\/strong>. In either scenario, the\ndirectional moves cancel out since the strikes are identical, so the profit\nopportunity comes from changes in the time value\/IV component of the option\nprices.<\/p>\n\n\n\n Since we have some metrics to determine when the earnings\nweek IV is relatively overpriced (which is pretty much always), pairing those\npositions with their inverse counterparts on a future week (like the following\nexpiration) provides near-complete directional hedging.<\/p>\n\n\n\n Employing a long calendar straddle provides a P&L\noptimized for outsized profits when the underlying moves less than the IV\nimplies. However, while it loses money when the underlying moves more than\nanticipated, those moves are largely dampened by the net gain in IV crush. It\u2019s\nalso important to note that while this trade shares a similar shape to that of\nthe short strangle or iron butterfly, its investment basis tends to be much\nlower as the cost of the far straddle is usually not substantially more than\nthe credit received for the near straddle.<\/p>\n\n\n\n The fair value of a calendar straddle is simply the\ndifference in extrinsic value between the long and short straddles. This means\nthat profit happens when that difference grows between the times you buy and sell\nit. Since we know that the extrinsic value of the short straddle will approach\nzero after earnings, we\u2019re relying on the long straddle retaining enough time\nvalue to exceed the net debit paid to open the overall strategy.<\/p>\n\n\n\n If the underlying doesn\u2019t move much, then all options are\nstill near the money, which means they\u2019ll retain the most extrinsic value.\nHowever, since both the IV crush and percentage of time remaining impact the\nshort week much more, the result should be a substantial profit.<\/p>\n\n\n\n On the other hand, if the underlying makes an outsized move,\nit usually results in an overall loss. A sharp move down, for example, would\ndrive the price of both calls to zero and the puts to their intrinsic value.\nThe extrinsic value of all options here zeros out because they\u2019re either deep\nin the money or deep out of the money.<\/p>\n\n\n\n Profit from moves close to the expected magnitude will\ndepend on a variety of factors. For example, a downward move within range should\nwipe out all value from the short call but may leave a small amount to be\nsalvaged from the long call. While both put legs will increase in value, the\nshort put will approach intrinsic value while the long put will hopefully\nretain some time value. The more the expiration week was overpriced, the more\nlikely the trade will be profitable.<\/p>\n\n\n\n In our analysis, long calendar straddles produced a\nremarkably outsized average gain for the $MSFT earnings releases in scope here.<\/p>\n\n\n\n *Note that the EOD midpoint pricing for the Jan 2016 trades\nindicated the long calendar straddle could be opened for $0.01 due to an\ninfeasibly high put ask at the near expiration. To account for this, trades\nusing that option were priced at the near put bid. This adjustment drastically\nlowered the long return and slightly raised the short return.<\/p>\n\n\n\n The long calendar straddle strategy was profitable 14 of the\n25 earnings periods analyzed here for an impressive average return of nearly\n33%. In fairness, this is using midpoint pricing, which is probably too\noptimistic. However, it gives a more realistic view of option pricing than the\nEOD bid\/ask spread leading into earnings. It\u2019s also important to recognize that\nthe average long calendar straddle had an opening cost of just 0.78% of the\nunderlying stock price. In other words, if the stock were trading at $100, the\ntypical long calendar straddle at close before the earnings announcement was\njust $0.78\/share.<\/p>\n\n\n\n Trade profitability was clearly dependent on the magnitude\nof the underlying move relative to its expected move. On average, they were\nvirtually the same at 2.91% vs. the expected 2.97. As a result, the strategy\nwas profitable 11 of the 13 times the actual move was less than the expected\nmove. There are a variety of reasons why those trades could have lost money in\ntheir respective scenarios that include issues like lower IV crush than\nexpected, poor option liquidity, or earnings IV richness.<\/p>\n\n\n\n Another important detail here is that the trade was\nprofitable 3 of the 12 times the actual move exceeded the expected move. This\nwas likely due to higher IV crush, better option liquidity, or more favorable\nearnings IV richness. This also explains how the trades still retained a fair\namount of value even when the actual move drastically exceeded the expected\nmove.<\/p>\n\n\n\n A close cousin to the calendar straddle is the calendar\nstrangle<\/strong>. It\u2019s the same conceptually, except that the call and put strikes\nare both OTM instead of ATM. While calendar strangles also profit from IV\ncrush, our analysis found them to be less successful overall due to\nsubstantially higher time value lost in the long strangle component. However,\nif there is strong evidence that the underlying will make an outsized move in\neither direction, picking the correct strikes for a calendar strangle should\noutperform the calendar straddle.<\/p>\n\n\n\n The data used so far in this analysis was limited to the 25\nearnings releases for $MSFT from 2016 through early 2022. To consider how these\nresults hold up across the broader market, we expanded the analysis to include all\noptionable US equities. The only refinement applied was to cull out stock that\ndidn\u2019t have strong option liquidity in order to focus on realistic market\nopportunities and minimize the impact of midpoint pricing.<\/p>\n\n\n\n To perform this filter, we only used earnings releases for stock\nthat had a Quantcha Liquidity Rating of 4 or higher on the last trading day\nbefore the release. This rating evaluates the option liquidity for stocks on a\ndaily basis and includes factors such as the number of option terms available,\ndistance between option strikes, volumes, open interests, and the bid\/ask\nspreads.<\/p>\n\n\n\n The final result produced 1,097 earnings releases across 434\nstocks between 2016 and the beginning of 2022. The qualifying releases skewed\ntoward the more heavily traded stocks and toward more recent releases, although\nquite a few smaller stocks also made the cut if their options were heavily\ntraded. About 15% of the releases were for stocks that only had one qualifying\nrelease make the cut.<\/p>\n\n\n\n Among these releases, the average 1-day return for the underlying\nwas around 50bps, although the average magnitude of the change was nearly 5%.\nOption volatility was slightly underpriced across these releases with an error\nof 37bps, which likely indicates that there was often significant interest in\nselling IV from the market.<\/p>\n\n\n\n Given the market\u2019s support for selling IV, earnings IV was\nmuch less exaggerated going into announcements. As a result of these tempered\nnumbers, earnings IV only crushed to 60% on average. However, that doesn\u2019t mean\nthat there wasn\u2019t real opportunity.<\/p>\n\n\n\n The first six trades above reference trading the ATM earnings\noptions. The calendar trades combine the earnings straddles with the inverse position\nat the next expiration.<\/p>\n\n\n\n Unlike the $MSFT trades, it appears that the better way to have\ntraded bullish returns was via long calls (as opposed to short puts). This\nlikely indicates that IV was underpriced going into earnings when the\nunderlying ultimately enjoyed a bullish move.<\/p>\n\n\n\n On the other hand, the more effective bearish trade was to\nsell calls, which suggests that IV tended to be exaggerated in cases where the\nunderlying ultimately dropped after earnings. Obviously, these sorts of\nconclusions are easy to presume in hindsight, so this is more speculation than actionable\ninsight.<\/p>\n\n\n\n The most striking data point, however, is the outsized rate\nof return for the long calendar straddle. While not quite the 33% seen for\n$MSFT earnings, it still averaged nearly 13%. This suggests that the\nopportunity to profit off of earnings IV crush may be consistently available\neven when earnings IV. The trade was profitable around 53% of the time with an\naverage return of 66% when profitable.<\/p>\n\n\n\n This report highlights some of the opportunities that exist\nwhen using options to trade earnings results. Here are some of the key\nconclusions we\u2019ve come to in the process of researching it.<\/p>\n\n\n\n Earnings IV crush is real and has been the most substantial\nand reliable opportunity lately.<\/strong> Strategies focused on selling IV\noutperformed other types of trades most of the time, regardless of the ultimate\nmove of the underlying. Data like IV across different terms and Quantcha\u2019s\nEarnings Crush Rate can help derive a richness metric to identify special opportunities\non a case-by-case basis.<\/p>\n\n\n\n Naked directional trades are generally not worth the risk.<\/strong>\nMost of the earnings releases in scope occurred during a bull run, but bullish\noption trades didn\u2019t generally pay well during the period. This doesn\u2019t\ninvalidate the notion of using directional option strategies when expressing a\ndirectional view, but simply buying calls during a bull run earnings period shouldn\u2019t\nbe assumed to outpace an underlying position. Even when you\u2019re right about direction,\nyou\u2019ll still need to be right about timing and magnitude to see a profit.<\/p>\n\n\n\n Option liquidity is an extremely important factor.<\/strong> Although\noption liquidity tends to be highest for stocks leading into their earnings\nreleases, it\u2019s not necessarily a guarantee of great pricing. As the strike\nmoves further from the money, there will be fewer market participants willing\nto take the other side of your trade, so consider data like the Quantcha Liquidity\nRating to locate opportunities worth pursuing.<\/p>\n\n\n\n Much of the volatility data used for this research came from\nQuantcha\u2019s US\nEquity Historical & Option Implied Volatilities<\/a> database available\nthrough NASDAQ. It\u2019s updated daily and includes over 60 daily volatility indicators\nfor historical and implied volatilities across terms ranging from 10-day to\n1080-day (3-year), as well as skew steepness measurements.<\/p>\n\n\n\n The Earnings Crush Rate and Liquidity Ratings used here came\nfrom Quantcha\u2019s US Equity\nOption Ratings<\/a> database available through NASDAQ. It\u2019s also updated daily\nand includes key option-derived data points for earnings, option liquidity, and\nIV valuation ratings like IV Rank, IV Percentile, and Quantcha\u2019s proprietary IV\nRating.<\/p>\n\n\n\n Quantcha provides tools, data, APIs, and research for some of the world\u2019s leading financial institutions, including top hedge funds, market makers, and quantitative traders. The Quantcha Options Suite has been featured in prominent trade publications for its innovative approach to the full options portfolio management lifecycle, including integration with major brokerages like Charles Schwab\u2019s TD Ameritrade, Morgan Stanley\u2019s E*TRADE, Tradier, and more.<\/p>\n\n\n\n For more information about custom tools, data, APIs, or research, please reach out to us at hello@quantcha.com<\/a>.<\/p>\n\n\n\n Ready to get started trading earnings with options? Check out Quantcha’s top 10 features for you<\/a>! <\/p>\n","protected":false},"excerpt":{"rendered":" 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. … Continue reading “An analysis of trading earnings releases using options”<\/span><\/a><\/p>\n","protected":false},"author":2,"featured_media":449,"parent":0,"menu_order":0,"comment_status":"closed","ping_status":"closed","template":"","meta":[],"_links":{"self":[{"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/pages\/431"}],"collection":[{"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/pages"}],"about":[{"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/types\/page"}],"author":[{"embeddable":true,"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/comments?post=431"}],"version-history":[{"count":12,"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/pages\/431\/revisions"}],"predecessor-version":[{"id":498,"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/pages\/431\/revisions\/498"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/media\/449"}],"wp:attachment":[{"href":"https:\/\/quantcha.com\/news\/wp-json\/wp\/v2\/media?parent=431"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}Goals<\/h1>\n\n\n\n
Why trade options\naround earnings?<\/h1>\n\n\n\n
How are earnings\noptions priced?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/i0.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/ExpectedEarningsMove.png?fit=840%2C636&ssl=1\")
<\/figure>\n\n\n\nWhat about trading earnings directionally with options?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/i2.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/TermTrades.png?fit=840%2C753&ssl=1\")
<\/figure>\n\n\n\nHow do we compare returns of long and short strategies?<\/h1>\n\n\n\n
How important is option liquidity?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/i1.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/TermTradesMidpoint.png?fit=840%2C751&ssl=1\")
<\/figure>\n\n\n\nWhat is implied volatility crush (IV crush)?<\/h1>\n\n\n\n
What is earnings IV crush?<\/h1>\n\n\n\n
How much does IV crush after earnings?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/i2.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/ActualCrush.png?fit=701%2C1024&ssl=1\")
<\/figure>\n\n\n\nCan we predict the earnings IV crush?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/i0.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/LongTermImpliedCrush.png?fit=840%2C802&ssl=1\")
<\/figure>\n\n\n\nCan we infer anything from the volatility surface?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/i1.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/EarningsCrushRate.png?fit=840%2C850&ssl=1\")
<\/figure>\n\n\n\n![\"\"](\"https:\/\/i2.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/EarningsIVRichness.png?fit=840%2C871&ssl=1\")
<\/figure>\n\n\n\nCan we still lose by selling overpriced IV?<\/h1>\n\n\n\n
How can we hedge against directional moves?<\/h1>\n\n\n\n
Iron butterflies<\/h3>\n\n\n\n
![\"\"](\"https:\/\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/IronButterfly.png\")
<\/figure>\n\n\n\nShort strangles<\/h3>\n\n\n\n
![\"\"](\"https:\/\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/ShortStrangle.png\")
<\/figure>\n\n\n\nIron condors<\/h3>\n\n\n\n
![\"\"](\"https:\/\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/IronCondor.png\")
<\/figure>\n\n\n\nThe problem with single-term trades<\/h3>\n\n\n\n
How do calendar trades hedge out directional risk?<\/h1>\n\n\n\n
How can we employ calendar trades to capitalize on IV crush?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/CalendarStraddle.png\")
<\/figure>\n\n\n\nLong calendar straddle profitability<\/h2>\n\n\n\n
![\"\"](\"https:\/\/i1.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/CalendarTrades.png?fit=840%2C611&ssl=1\")
<\/figure>\n\n\n\nA note about calendar strangles<\/h2>\n\n\n\n
How does this analysis hold up across the broader market?<\/h1>\n\n\n\n
![\"\"](\"https:\/\/i2.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/BroadMarketExpectedEarningsMove.png?fit=840%2C87&ssl=1\")
<\/figure>\n\n\n\n![\"\"](\"https:\/\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/BroadMarketActualCrush.png\")
<\/figure>\n\n\n\n![\"\"](\"https:\/\/i0.wp.com\/quantcha.com\/news\/wp-content\/uploads\/2022\/04\/BroadMarketAllTrades.png?fit=840%2C57&ssl=1\")
<\/figure>\n\n\n\nKey conclusions<\/h1>\n\n\n\n
Data used in this research<\/h1>\n\n\n\n
About Quantcha<\/h1>\n\n\n\n