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Publicly traded companies in North America generally are required to release earnings on a quarterly basis. These announcements, which contain a host of relevant statistics, including revenue and margin data, and often projections about the company's future profitability, have the potential to cause a significant move in the market price of the company's shares.
From an options trading viewpoint, anything with the potential to cause volatility in a stock affects the pricing of its options. Earnings releases are no exceptions. Options traders often try to anticipate the market's reaction to earnings news. They know implied volatilities, the key to options prices, will steadily rise while skew - the difference in implied volatility between at-money and out-of-the-money options - will steadily steepen as the earnings date approaches.
The degree by which those adjustments occur is often based on history. Stocks that have historically made significant post-earnings moves often have more expensive options. Earnings risk is idiosyncratic, meaning that it is usually stock specific and not easily hedged against an index or a similar company. Stocks that are normally quite well correlated may react quite differently, leading to share prices that diverge or indices with dampened moves.
For those reasons, there is no single strategy that works for trading options in these situations. Traders must have very clear expectations for a stock's potential move, and then decide which combination of options will likely lead to the most profitable results if the trader is correct.
If the market seems too sanguine about a company's earnings prospects, it is fairly simple though often costly to buy a straddle or an out-of the-money put and hope for a big move. Taking advantage of the opposite prospect, when front month implied volatilities seem too high, can also be profitable but it can also cause serious losses to be short naked options in the face of a big upward stock move.
Traders can take advantage of high front month volatility by buying a calendar spread - selling a front month put and buying the same strike in the following month. The maximum profit potential is reached if the stock trades at the strike price, with the front-month option decaying far faster than the more expensive longer-term option.
Losses are limited to the initial trade price. Sometimes excessive fear is expressed by extremely steep skew, when out-of-the-money puts display increasingly higher implied volatilities than at-money options. Traders who use vertical spreads can capitalize on this phenomenon. Those who are bearish can buy an at-money put while selling an out-of-the-money put. This allows the purchaser to defray some of the cost of a high priced option, though it caps the trade's profits if the stock declines below the lower strike.
On the other hand, those who believe the market is excessively bearish can sell an out-of-the-money put while buying an even lower strike put. Although the trader is buying the higher volatility option, it allows him to make money as long as the stock stays above the higher strike price, while capping his loss at the difference between the two strikes.
This article is provided for information only and is not intended as a recommendation or a solicitation to buy or sell securities. Option trading can involve significant risk. Before trading options read the " Characteristics and Risks of Standardized Options. What is the margin on a Butterfly option strategy?