Earnings Volatility: Friend or Foe?

When a company has an earning’s conference scheduled, many times there is speculation not only in regards to the accuracy of the projected earnings per share (EPS), but to several other factors as well. These include but are not limited to sales and revenue streams, products in the pipeline, cash on hand, management changes, possible future stock or bond offerings, etc. The uncertainty may cause volatility in the shares themselves, but the diamond in the rough is actually the temporary parabolic increase in the exchange listed options on the underlying shares. Traders tend to stay on the sidelines going into the days leading up to the earnings conferences. Call buyers swap out shares of stock for long call options so they can participate in a rise should the shares move higher and limit the potential loss should the shares trade lower. This causes the call options to trade in many cases, at drastically expanded volatility levels. Additionally, put buyers force the options higher as they try and protect their positions.

From a trader’s perspective, the opportunity to capitalize on the potential volatility allows them to capitalize with limited risk via verticals, butterflies, and diagonal spreads. A long vertical spread is simply a long call at a lower strike and a short call at a higher strike or a long put at a higher strike and a short put at a lower strike; normally in the front two months where premium is most sensitive and susceptible to theta (time decay). This is especially the case if the earnings are in the last week prior to expiration. The long butterfly is similar but it is achieved by buying a long vertical and selling a short vertical with a common short strike. The long diagonal is achieved by selling a front month option and buying a back month option of the same type, put or call, on different strikes. The trick is to devise a way to use options to your advantage to benefit from a potentially large swing either up or down.

The first step is to identify and qualify a particular stock by looking at past performance of the stock’s movement heading into earnings and finding those stocks that have the earning calls closest to expiration. Certain stocks like Intuitive Surgical Inc. (ISRG), Priceline.com Inc. (PCLN), and Google Inc. (GOOG) are prime examples of stocks that have the potential for large moves and have earning calls close enough to expiration.

The second step is to take a look through back testing, what volatility has done previously at those points in time Traders should be looking for dramatic increases in front and second month volatility a few days prior to the earnings call. ISRG front month volatility is usually around 30% +/- 3% with earnings scheduled a couple days before expiration and can move 50 or more points either way. This makes the stock a potentially great candidate to look at. Patience is key as well as identifying several stocks that fit the parameters to justify the placing the trades. Normally the volatility doubles and in some cases, it can be even more extreme than that. This is what traders need to look for. For this very reason, it is essential to have several stocks to watch closely due to the fact that they may not all present an equal opportunity to place a trade. Remember the goal is to take advantage of the temporary rise in volatility.

Looking at ISRG as an example and going back to July of 2012, the earnings date and conference was set for Thursday July 19th, 2012; one day prior to July expiration. Two weeks out from the July expiration, volatility began to increase from the mid 30% range moving up to the mid 80% range in the earnings week and topping out at 120% on July 19th. The shares had rallied from June 4th, 2012 from a low of $498.01 all the way up to a high of $569.95 on July 3rd eventually settling in at the $545 range on July 17th. The July 485/Aug 490 Diagonal Put Spread closed at $3.425. On July 20th expiration, one day following the earnings conference, the same spread closed at $9.175 representing roughly a 260% profit over a three day period.

The ISRG July 515/500/485 1x2x1 put butterfly spread closed at $1.10 on July 17th. On July 20th the spread closed at $12.525 representing a 1,150% gain in a three day period. The July 510/500 long put vertical closed at $1.10 on July 17th and closed in the money on July 20th at its full value of 10 points or $10.00 which represents an 890% profit in a three day period.

Looking at PCLN, volatility normally trades around 30% +/-5%. Back in August of 2012, the earnings conference was set for August 7th, 2012 and volatility had crept up over the weeks preceding the earnings call; moving up to 58%. The stock had settled into the $640 - $680 range, closing near the high of the range at $679.80. The Aug 580/Sept 585 put diagonal closed at $5.425 on August 7th and on August 17th expiration that same spread closed at $16.075, almost tripling in value.

The PCLN Aug 610/590/570 long put butterfly closed at $0.80 on August 7th. That same spread closed at $18.725 at August expiration netting the investor a profit of $1,792.50. Volatility had dropped back off, settling in at the 27% range. In both the cases for PCLN, the trades were over a 10 day period and timed to coincide with earning calls, increases in volatility and expirations.

There are no guarantees that the trades made will profit. But the timing and increase in volatility are conducive to creating the ability to produce less expensive, cost efficient trades with a higher percentage of profiting. Looking at what the stock has been doing going into the earning calls as well as gauging the volatility at that particular point in time, is a key factor in helping to determine the right spreads based on risk tolerance verses the potential reward. Grasping the concept that increases in volatility can be utilized to the investors advantage is something that is at the very least should be considered and not feared.

Ross Barnett Terry, Contributor

Trader Education