Earnings plays - This is my strategy and reasoning behind the GOOG play

Earnings Plays

Well it's almost getting into the start of Q2 earnings season so I'd like to share a couple of the strategies that I like to employ. I have two different strategies regarding earnings. One strategy is for earnings that are released just prior to options expiration whilst the other is for earnings that are released just after options expiry. The way both of them work are very different. I'll explain below.

Earnings released just before options expiry.

The foundation for this strategy is primarily a volatility play. The assumed edge comes from betting that the realized volatility after earnings will be less than the implied volatility. Hence we want to be short vega going into earnings and ideally our entry point is when the implied vols are at or near their typical pre-earnings levels (check implied vol chart). Note that there is an inbuilt edge here as typically the realized volatility is much less than the implied or else the market makers would be losing a bunch each and every earnings season to the straddle and strangle buyers. Therefore the probabilities are in the favour of those selling volatility but expect to lose significantly when the trade does goes against you eg. on a big move (similar characteristics to an income trade?? - maybe but we can increase our odds/edge - I'll give reasons below). So what are the short vega strategies that I like to employ? They are primarily the broken wing butterfly (with the wings spread out as far as I can) and the unbalanced butterfly in the ratio of 1/3/2 ie it is just like a normal butterfly but with an extra embedded credit spread (see example below). Both trades should be done for a credit or at least even. The reasons the trade should be done for a credit:

1) Is to give us one breakeven. As we expect the stock to move after earnings we want to only bet on one side of the movement and hopefully be on the right side. This further improves the probability of success in the trade.

2) To ensure you are getting a risk to reward of one to one in the trade (always my minimum goal with these types of trades).

Next we want to ensure that the wings are spreads as far as possible for two reasons:

1) To provide greater price protection in the event the stock does move and

2) to enhance the probabilities of profit when the implied vols do collapse as the volatility curve (the time value curve) for the out of the money options will decay much faster than the one you bought (closer to the money).

Finally, to increase probabilities even further, we want to look for stocks that have earnings just prior to Op Ex. Why? Well there are 2 reasons:

 1) we are taking advantage of the fact that the market makers have to keep the implied vols extremely elevated going into earnings even though it is near options expiration and premium should be decreasing (due to theta) because they don't want to get caught out on big move, hence when earnings is announced, the collapse in volatility is enormous (good for sellers).

2) if the stock does move after earnings, we would expect some follow through. However, the fact that Op Ex is just around the corner, you are safe with the knowledge that the move is limited to within that time frame.

The other things I like to do in my analysis of each trade is:

·         Ensure that the breakeven is outside of the 1 std deviation expected move at expiration

·         Ensure that you model realistically how much the implied volatility will breakdown after earnings combined with the price move to see the effects on your profit and loss.

Earnings released just after Options Expiry

This is not so much of a volatility play as it is more of a directional bet. The assumption and basis for this trade is that the stock will not much move prior to earnings and the probability is that the current prevailing trend will continue.

As the play here is not so much to do with volatility but with direction then one could employ any strategy that they see fit, but my preference is still for short vega strategies. Here I still like to use the broken wing and unbalanced butterfly but you will find that because the implied vols are not high, you will seldom be able to put these on for a credit. Hence my preference for just the regular butterfly with a good risk to reward (1:3) or an iron condor.  Again to reiterate, the assumed edge is that the underlying will not move significantly prior to earnings as no one wants to make a big bet, however, it the general market does sell off then that could drag the issue down with it so one needs to take this into account (another reason why I like the regular butterfly as it has better risk to reward characteristics).

If anyone has anything they wish to add, suggest or critique, I'd be happy to hear it.

Good trading!