One exciting time to be paying attention to a stock is when the company is about to report earnings. The same can be said for options. When a company releases earnings, they provide the most recent financial performance and also provide Wall Street with their guidance for the next quarter.
There are certain strategies that can be used when trading options right before a company reports earnings. When a company releases earnings, everyone is wondering how the company did. Even if a company beats expectations, it may still miss on guidance. The stock can go up or down in a short amount of time when the earnings are released.
The uncertainty of how the company’s earnings will look, is translated into the options market through implied volatility. Implied volatility is what investors use to predict what will be the future movement of the stock.
If there is a higher implied volatility, the higher the expected movement. Volatility will start to increase into earnings as investors are uncertain as to which way the market will take the stock. The rise in volatility also increases the option premium making everything more expensive. When earnings are released, the volatility will significantly drop because there is no uncertainty any longer. Called a volatility crush, the price of options are then lowered.
The option trade to take that is best during earnings are long options. Surprisingly most traders believe against this because they think volatility crushes the premium too much to make these trades profitable. The fact that companies report earning surprises is what makes long options successful.
When a company releases, their earnings is when you want to exit the option position. It’s best to wait until the end of the day to get the most movement out of the stock and exit the position then. However, do not hold if you think don’t think it will move any more. The chance of success will drop off dramatically the longer you wait, and the position will lose more money. Cut your losses then.