Years ago, I never thought it made sense to trade earnings. It was a mostly a foreign concept; due to numerous limitations, trading earnings announcements just didn’t make sense from an efficiency standpoint.
Well, things have changed.
Add 52 weekly expiration cycles and a variety of highly liquid products and the clarity of a once-unknown calculation . . . and we now have the opportunity to trade earnings news in an efficient and informed manner.
The unknown calculation? Expected move.
What is expected move?
It’s the price movement the market expects during a given expiration cycle. It’s the key to successfully trading earnings announcements. Fortunately, now we have tools that allow us to see, in real-time, the expected move for any given underlying stock around an earnings announcement.
Let’s look at an example using Wells Fargo (NYSE: WFC), which released earnings at the open on Friday, January 12, 2018.
As expected, implied volatility (IV) is high as we move closer to the uncertainty of the WFC earnings announcement. We ALWAYS want to see heightened levels of IV when seeking trading opportunities around earnings. Increased levels of IV means inflated options prices . . . basically, that we can sell options for more premium than usual.
We have several tools at our disposal to figure out what the expected move is for Wells Fargo immediately following the company’s earnings announcement.
The easiest way is to just look at your trading platform. As you can see, the expected move for WFC is roughly +/- $1.07 by Friday, Jan. 12 or $1.45 by Jan. 19, according to the Thinkorswim platform.
You can see the expected move embedded in the options chain on the Tastyworks platform.
Knowing that the expected move is $3.75 gives us the opportunity to utilize a variety of strategies based on our market assumptions in WFC (bullish, bearish or neutral).
I tend to stick with risk-defined, neutral-based strategies like iron condors.
For instance, if we know the expected move in WFC, we can create a range-bound trade around the expected range as seen in the WFC options chain above.
We could sell a 2 strike wide iron condor at the 65/67 – 60.5/58.5 strikes for roughly $0.31.
Our short strikes 65 – 60.5 give a fairly wide range of $4.50. And as long as WFC shares trade within that range immediately following the company’s earnings announcement, we should be able to buy back the spread for a nice profit due to volatility crush.
The probability of that occurring is roughly 83.05% on the downside and over 82% on the upside. The uncertainty (and associated risk) of the binary event will have passed and volatility will immediately push back to normal levels.
The decline in volatility affords us the opportunity to take advantage of some nice profits. They call it “volatility crush” and I’ll show you exactly what this means.
Just remember: When trading earnings you should use a small, consistently defined percentage of your capital per trade, as the strategy is inherently more risky due to the binary nature of the trade.
I’ll be back next week with an update on how the trade performed. Stay tuned!