All publicly traded stocks report earnings at the end of each business quarter. Many will refer to these few weeks of time as “earnings season” with many stocks reporting their quarterly earnings each evening after the market closes or, in some cases, in the morning before the market opens. For many stocks this is an extremely volatile time for the stock’s share price. Stocks like Google may jump or drop $50 or more overnight. Your stock or options broker’s web site will have information available about which companies are scheduled to report, on which date, and whether the announcement will occur before the open or after the close of the market.
There are many ways to trade the earnings announcement. I will focus on the calendar spread in this article. A calendar spread (also known as a time spread or a horizontal spread) is created by buying an option in a future expiration month, and simultaneously selling a front month option at the same strike price. Calendar spreads may be created with calls or puts. With the recent advent of weekly options, a new wrinkle has been made possible, i.e., selling the current weekly option and buying an option in the next expiration month.
The ATM (at the money) calendar spread is created with the strike price nearest the current price of the stock. For example, if XYZ is trading at $164 on February 4 with expiration of the Feb options on 2/18, one might sell the XYZ Feb $165 call option and buy the Mar $165 call option. Since the option with more time to expiration will always be more expensive, calendar spreads are always debit spreads, i.e., we establish the spread for a net debit (money flows out of our account) and we close the calendar spread for a net credit (money flows into our account).
Calendar spreads have two principal areas of risk over the course of the trade: 1) the underlying stock price ranges too far up or down, and/or 2) the implied volatility of the options in the spread decline.
Calendar spreads are known as trades with high “vega risk”. Vega is the Greek that measures how much our position will gain or lose in value as implied volatility changes. ATM calendar spreads always have large positive values of vega; thus, if implied volatility decreases, the trade loses value and if implied volatility increases, the spread position gains in value.
The calendar spread can often be successfully traded on a stock with an imminent earnings announcement because the implied volatility of the stock’s options tend to increase as the date of the earnings announcement approaches. But the calendar spread must be closed before the announcement because implied volatility will collapse immediately after the announcement and this will kill the value of the calendar spread.
In general, the process to be followed is:
1. Look at the chart of implied volatility for the stock candidate and confirm that it has risen significantly before previous earnings announcements. You can find this chart on your broker’s web site or at iVolatility.com.
2. Establish the calendar spread about 2-3 weeks in advance of the earnings announcement. An alternative is to establish the spread about one week in advance of the earnings announcement, selling a weekly option and buying an option in the next expiration month. Or one may establish several trades by selling weekly options two or three times in advance of the earnings announcement.
3. Monitor the gain/loss of the position each day. If the loss exceeds 15%, close the trade.
4. If the earnings announcement is scheduled to occur after the market’s close, then close the position on the day of the announcement. If the earnings announcement is scheduled to occur before the market opens, then close the position on the day before the announcement.
5. Closing the spread for a loss will occur if the stock price runs too high or drops too far during the course of the trade. If you believe the stock price is likely to rise during the course of the trade, use a call calendar spread; if you judge the price risk to be to the downside, then create the calendar with put options.
As long as implied volatility increases somewhat uniformly between the front month option and the future month option, the position will appreciate in value. The position may lose value if an implied volatility skew develops where the implied volatility of the front month option increases much more than that of the future month. In this brief article, I can’t go into all of the details of the implied volatility dependence of the calendar spread.
In summary, the ATM calendar spread is an excellent way to trade earnings announcements. The downside risk for the trade comes from two areas: 1) the underlying stock price runs too far up or down while in the position, and 2) the implied volatility of the sold option increases far more rapidly than the implied volatility of the option purchased.
Kerry W. Given, Ph.D., aka Dr. Duke, is the author of No Hype Options Trading and is a frequently invited speaker at trading conferences. He can be reached at:
http://www.ParkwoodCapitalLLC.com
© 2011 Parkwood Capital, LLC. All Rights Reserved.
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