NEW YORK (Options Trading Signals) -- Trading stock around the times of earnings releases is a notoriously difficult operation because it requires accurate prediction of the direction of price movement. Wrong predictions can expose the trader to substantial loss if large unexpected moves occur against his position.
Because of the risk associated with these events, many traders use options to define their risk and protect their trading capital. Here I present several approaches to using options to capture profits during the earnings cycle and to help present the logic and call attention to a major potential pitfall of using these vehicles in this specific situation.
It is essential to recognize that as earnings announcements approach, there is a consistent and predictable pattern of increase in the implied volatility of options. This juiced implied volatility reliably collapses toward historical averages following release of earnings and the resulting price move.
A real world example of this phenomenon can be seen in the options chain of Apple (AAPL) which will report earnings Tuesday afternoon. The current options quotes are displayed below:Notice the implied volatility labeled as "MIV" in the table above for the 605 strike call. The volatility for the front series, the weekly contract, is 59.6% whereas that same option in the September monthly series carries a volatility of 28.3%. This is a huge difference and has a major impact on option pricing. If the weekly carried the same implied volatility as the September option, it would be priced at around $7.70 rather than its current price of $16.50! The value of the implied volatility in the front month options or front week options allows calculation of the predicted move of the underlying, but it is silent on the direction of the move. A variety of formulas to calculate the magnitude of this move are available, but the simplest is perhaps the average of the price of the front series strangle and straddle. In the case of AAPL, the straddle is priced at $33.80 and the first out-of-the-money strangle is priced at $28.95. So the option pricing is predicting a move of around $31.50. This analysis gives no information whatsoever on the probability of the direction of the move.
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