2. Know the stock's history of gaps, and find relatively cheap options to trade the average gap

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Shauna Stephens
6 years ago
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1 MY TOP 5 EARNINGS TACTICS FOR OPTIONS TRADERS... INCLUDING MY #1 OPTIONS STRATEGY FOR EARNINGS SEASON Introduction Why trade around earnings? Any option buyer knows that the ultimate options purchase is one that moves sharply in the least amount of time possible in order to minimize time erosion in the option. Earnings provide opportunities for sharp price gaps, in some cases instantly or usually overnight. In this report, I will detail the times where I like to trade options in front of, as well as after, the earnings event. You want to make sure you line yourself up for the best opportunities for big moves but relative to the market's expectations. If the market already expects a big move, you have to be careful buying options and in this report, you will learn how opportunities exist for a rarely used options strategy when expectations for a big move get overdone. Overview of My Top 5 Tactics There are many potential strategies for earnings season and here are my top 5 favorite techniques to consider. I will overview each of these strategies in this report, and then share with you my #1 favorite earnings strategy to consistently profit from earnings reports over time. 1. Buy well in front of earnings, sell before the event 2. Know the stock's history of gaps, and find relatively cheap options to trade the average gap 3. Buy straddles or strangles to play a big move in either direction 4. Consider a time spread, where you sell relatively high implied volatility in short-term options right before earnings and then you buy more time relatively cheaply as a hedge 5. Buy after earnings and follow the trend

First, A Quick Primer on Volatility While "volatility" is often thrown around as a broader term relative to market risk, it actually is a specific measurement of movement in the options markets.

2 First, A Quick Primer on Volatility While "volatility" is often thrown around as a broader term relative to market risk, it actually is a specific measurement of movement in the options markets. Historical Volatility (HV) is the actual movement that the stock has had over the lookback period. Implied Volatility (IV) is how much the market expects the stock to move going forward. The tendency is for the IV to rise ahead of an event, and then revert back down after the event has passed as you can see in the chart below. So we want to make sure that if we are buying an option ahead of earnings, that we don't buy too much IV that's well ahead of HV. There are times when IV has not spiked much and the coming volatility from the earnings news is actually greater, sometimes much greater, than the market expects. Therein lies the opportunity.

Straddle Pricing Ahead of Earnings I like to look at the total cost of the shortest-term options, closest to expiration, to see how the options are priced.

3 Straddle Pricing Ahead of Earnings I like to look at the total cost of the shortest-term options, closest to expiration, to see how the options are priced. The straddle is if you bought BOTH a call and a put near the current price of the stock, known as the "at-the-money" or "near-the-money" straddle. So look at the chart below as an example: If you were buying the Apple (AAPL) April 11th (weekly options) 530 call AND also buying the 530 put, that near-the-money 530 straddle would cost a total of to purchase immediately (6.75 asked for the call plus 4.75 asked for the put). That means that the buyer of this straddle has to expect the stock will move up or down by more than points above or below 530. Why? Because if the stock doesn't move and finishes at the April 11th expiration right at the strike price of 530, then the worst case happens where both the call and the put expire worthless. The best case is a monster move in either direction. The effective breakeven on this straddle at the expiration is points above 530, or (call is worth and put is worth 0), or points below 530 at (put is then worth and the call is worth 0). We break this down in percentage terms for every example we look at, so points divided by the strike price of 530 is a 2.17% move in either direction. So if you actually see a 4.3% move, you're looking at doubling your investment on the straddle. Note in this case that AAPL does not have earnings anticipated laterin April, but this straddle pricing approach can be used to estimate the expected implied volatility for a stock based on the option's market pricing. As a side note, how does the option's market reach this expectation of how much the stock will move? Based on market participants' interest in buying or selling those premiums. If the market maker initially set the straddle pricing at 4% implied volatility and other players thought the actual move would be 2%,

4 traders would sell the straddle and the pricing of the options would adjust downward. So over time, you are looking at the consensus expectations for the entire market on how the stock should move based on the options pricing.

5 Gap History So you're thinking about buying an option on Google (GOOG) ahead of its next earnings. A first step is to look back at least 6 quarters, and see how much the stock has gapped in the past: Gap from Prior Day's Close to Next Day's Open October % July % April % January % October 2012 NA (company accidentally released real-time 1 day before!) July % AVERAGE +2.81% So if you see the upcoming earnings quarter's options priced like this, what would you do? Given that the April 545 straddle is priced at a total of points, or 7.01%, I'd say the market has potentially overreacted to the big move last quarter, and with volatility expectations more than double the average of +2.81%, it's certainly not a straddle I'd want to buy. So should you sell it? Over time, net sellers should benefit, but individual situations can still have big gaps (against you if you did a selling strategy), so I don't tend to sell these options in front of events, unless I want to create a time spread. P.S. I did tell my workshop students ahead of GOOG's prior report that the at-the-money straddle was too cheap, priced around 4% move expected. The end result was a move more than double expected, as

6 the straddle gained around +150% on the 10% gap up. So clearly the market tends to remember (and perhaps overly adjust to) what just recently happened in the prior quarter.

What's a Time Spread? Also known as a Calendar Spread, here's how it works: Let's say you're bullish GOOG, and think the 545 call in April is rich, trading around 18.

7 What's a Time Spread? Also known as a Calendar Spread, here's how it works: Let's say you're bullish GOOG, and think the 545 call in April is rich, trading around with an implied volatility of 45% before the earnings due after the close on April 16th. You might create a calendar spread by selling this option while simultaneously buying the May 545 call for (a 33% implied volatility). So your net cost on each spread is 6.00 ($600 debit per contract). What scenarios could occur? A big gap up, a milder than expected move up, a flat market, a slight edging down or a bigger down move. Remember that selling the April 545 call at is like saying I think the stock will not go over at expiration (545 strike price plus the premium you collect upon selling). So obviously a move above that is not desired in this strategy, though you would offset losses over 563 by the May 545 call going up nicely, but not quite as quickly due to the extra time you purchased. A big down move hurts you since you are a net buyer here, though an initial flat to down market causes the April option to expire and you pocket that premium and if the stock can then snap back you can exit your May option on a bounce to leg out and make the trade pay off. A move down of more than the 18 points you collected is basically what you don't want. Most desired is relatively less movement which helps the April option premium implode and the May will still hold its value relatively better due to more time remaining there. Here's a chart of how that calendar spread looks if both sides are held to expiration. So less movement into and after the earnings is desired until the April option expires, ideally right at or just under the strike price sold at 545. Then your April option would go away and you'd still have your May option to hold or exit with plenty of value remaining. And there's a relatively wide range of

8 scenarios where you can make some money, especially if the stock doesn't gap as much as expected. Here's a chart sample of a Google (GOOGL) trade I opened on January 29, 2015, to see how the trade set up, courtesy of OptionsHouse.com: You can see how the trade was placed for 3 contracts for a 3.40 net debit per contract, or a total cost of $1,020 before commissions. These trades will all be net debits, as we're selling the shorter-term options and buying the same strikes further out in time. But when the implied volatility is relatively higher in the short-term options we sell, it allows for a significant reduction in the total premium you pay. You can see how the best case scenario is for the stock to finish right on the strike price on either side, but there's usually good profit potential too anywhere in between the strikes, and even some profit as the position moves outside either strike price. It's where the stock moves dramatically beyond those strike prices that you need to be vigilant about exiting early before the shorter-term options expire. As it turned out, GOOGL dropped at first, but not nearly as much as expected, which allowed me to buy back the short-term options very cheaply once the implied volatility imploded the next morning. Then GOOGL had a sharp rally up over 530 to 537, allowing me to exit the 530 call for a big gain, resulting in a +250% profit on the overall position. Note that this includes letting the put I owned expire with no value, as it's similar to a straddle - or in this case it's like a strangle play, where you just need movement on one side to make money after you get out of your shorter term options that you sold. And since you lowered your net cost significantly on the options you bought via the double diagonal, you don't need nearly as much of a move to be profitable compared to the normal strangle trader.

Buying After Earnings to Ride a Trend While perhaps not as thrilling to buy after a potential gap, it's often lower risk with still plenty of reward potential.

9 Buying After Earnings to Ride a Trend While perhaps not as thrilling to buy after a potential gap, it's often lower risk with still plenty of reward potential. Check out this example of Facebook (FB) which offered numerous opportunities. As you can see with FB shares, the initial breakout using my indicators like Percent R and Acceleration Bands (I also use others to confirm a move, but let's focus on these) show that FB broke out first with Percent R in early July 2013 and confirmed that move about 2 weeks before the earnings hit. The stock was around 25.50, and it even gave a first retest just 1 week after the first buy. The retest shows a spot where the stock's trend should hold. This was 3 days before the earnings. Upon the earnings, the stock gapped up from 26 to 33, giving those willing to play the bull trend a profit of over 150% on the August 26 calls. But for those who missed the gap, there were more opportunities. The confirmed breakout above the gap day high now around 35 gave the chance to ride the September 35 calls up to the mid-40s, again offering more than 100% returns on average on the whole position (we often exit half of our position earlier than 100% and then try to ride the rest up to 100% or more).

10 And if you missed this first After Earnings opportunity, you still had not one but two retests to hop back on the uptrend. Retest #1 went from 43 in mid-september to 50 two weeks later, while Retest #2 in early October gave a chance to position ahead of the next earnings two weeks after that. That move went from 48 to 55. Generally, if I'm in well advance of the earnings date, I like to sell off half my position at a double if I can to get my risk capital back before the event. The rest of the trade is essentially a free trade at that point, which can lead to even bigger potential profits while not stressing the account if the gap goes the wrong way. As far as downside examples, check out this chart of retailer Best Buy (BBY): BBY was already breaking down on percent R for starters (Percent R will usually lead Acceleration Bands) with a confirmed sell at $37 per share. The stock edged lower for 3 sessions then bounced the day before earnings, showing what I call a Bear Retest. This bar's high must hold as resistance, and it often shows a good entry point within the evolving downtrend. The next day BBY gapped down on disappointing earnings from the Christmas season, falling from 37 to 26 overnight! Put buyers had the opportunity to clean up on the February 37 puts which went up more than 300%. The stock did show some After Earnings potential as well (though I would always book at least half of my gain on the windfall gap move in my favor).

11 This leads me to my #1 favorite strategy for trading options around the earnings report: Trading Options immediately AFTER the earnings are released. The primary considerations to merit making a quick post-earnings trade are these: 1) Only trade in the direction of the reaction - We're not going to try to fade or go against the market's initial reaction, but rather will watch the initial gap and then use short-term technical analysis to show if the market is supporting the stock by buying more after a gap up, or selling more after an initial decline. 2) Buy Options that are Deep In the Money - The high implied volatility we discussed earlier in front of the news will start to normalize at lower levels fairly quickly, but it may take several hours to truly adjust fully. This makes the at the money and out of the money options still speculative and higher-risk choices compared to the in-the-money (ITM) options where a vast majority of the ITM is based on the stock price rather than the remaining time until expiration. This vastly neutralizes the IV effect and allows us to trade options as a stock substitute for a leveraged effect that is often around 10 times the percentage move in the underlying stock. 3) Buy Options with a bit more time than you need - While our average holding period for our BigTrends Earnings Explosion trades is roughly 3 trading days, we find the liquidity in the monthly options to allow us to have more favorable prices than the shortest-term weekly options. This gives up a little leverage but it is well worth it for the greater stability and tighter bid/ask prices on the monthly options, allowing us to lower our execution costs over time. 4) Be ruthless about exiting on patterns that are not continuing after the gap - We've found that for the quick trades after earnings, the proper pattern is a steady and persistent uptrend as evidenced by the 5-minute Percent Range (%R) indicator. If a stock is making higher highs (or lower lows), then the indicator will stay overbought (or oversold) longer than most would expect. But once we violate that overbought or oversold period, a stock can go into a range or a reversal. So we always alert our clients in real time when it's time not just to get in, but also when to get out. Let's look at a couple of examples, starting with a bullish call purchase on Stratasys (SSYS). You can see from the chart that the stock gapped up, so the market's initial reaction was positive. That would only let us consider a call and not a put. We've created an upper and lower band we call Bigtrends Bands, which tracks the overbought and oversold levels of the Williams Percent Range (%R) indicator. You will notice we were comfortable buying the first dip back under the upper band as this is often a good risk/reward spot to buy the "retest" that Price Headley has gained acclaim for, showing traders how to hop on a trend move at an optimal risk/.ward entry point near the likely support within the evolving uptrend. You can also see that the best moves for the stock occur outside the upper band, as there is no natural resistance while the uptrend is working its way higher. We like to take a first half of the position at a healthy profit target around +30%, as our stop is usually around -30%. Then we'll seek to stretch to as much as +100%. This trade made a bit more at +115% on the second half position. We call these big intraday trend trades "runners" as the trend continues to run, and helps run up your

12 portfolio as well. Note that this was indeed a day trade, which is not our intent but does happen on some quick profits or quick stops. We have a rule to not have more than 3 day trades in a 5 consecutive day period, to avoid any risk of being classified as a pattern day trader (which thus allows even small accounts to benefit from our After Earnings strategy here). Next let's examine a bearish put buy we recommended on Monsanto (MON): You can see the initial reaction on the downside, and while the stock had a sharp move up to fill a good part of the gap down, this was an ideal retest situation. The beauty of retests is that if the downtrend is going to continue, the retracement should stall at the retest resistance and then start heading lower. The additional benefit of buying an In The Money Put here is that we can afford to wait through the initial stall as the upside bounce rolls over, compared to more pressure felt by more aggressive options buyers who risk losing great time and volatility premiums through a flattish retracement. MON puts hit their first target at +30% and then made a bit more on paper which caused us to tighten our trailing stop, resulting in a 26% gain on the second half of the trade when the stock started to reverse higher.

13 2016 UPDATE: You will notice from the chart below of the first quarter 2016 BigTrends Earnings Explosion (BEX) trades that they are exclusively In the Money options purchases. Why not do any other earnings strategies? Because ITM Options after earnings accomplish a double goal: consistency with healthy upside potential. That's why the "After Earnings" Options Purchase has become my #1 favorite "go to" options strategy for earnings season. While most know the main earnings periods as January, April, July and October, the fact is that many companies have fiscal years that are not aligned with the calendar quarters. So I expect to do these trades at any time throughout the year, right in front of an earnings report.

Past performance is no guarantee of future results. Commissions are not included, so factor your commission rates into trade examples. All trades involve risk of loss.

14 Past performance is no guarantee of future results. Commissions are not included, so factor your commission rates into trade examples. All trades involve risk of loss. Every trader should educate themselves on options by reading the booklet entitled "Characteristics and Risks of Standardized Options" available here:

15 A look at the results of all trades made from the first quarter of 2016 in my earnings alert service called BigTrends Earnings Explosion shows the type of "win big, lose small" approach I'm typically seeking with the quick trades after earnings strategy. Out of 27 trades there were 15 winners for a 56% win rate. Anything over 50% winners is usually good for options buyers, assuming you use tight stops to keep losses down while letting winners run to be bigger on average. The big miss was a gap up in Amazon (AMZN) more than I expected, and the plan in those situations is to shut down the trade very soon after that bigger than expected gap. Q&A What type of stocks should you use? I prefer growth stocks, as they have the greatest potential to move. Therefore, the options tend to get priced richly in front of earnings which creates opportunities for Double Diagonal traders. They also can have bigger volatility so these trades must be managed appropriately after earnings. Should I prefer puts or calls generally? Given that the trend has been around 70% of companies in the S&P 500 beating earnings estimates, with an average one day change of +0.47%, the bias should be to the upside over time. However, there are dramatic opportunities when a company surprises with an earnings miss, so we stay flexible on both sides of the market. Where do you get the earnings dates? Start with Yahoo's earnings page for example: It defaults to today's earnings releases, and you can scroll ahead to upcoming days as well. You can search by company stock symbol, as well as get an overview of the day to day list of companies with earnings due. I'll confirm this with the company's Investor Relations department if needed on the exact timing of the earnings release (before the open or after the close on a certain day) to make sure I have the correct date and time. What about pre-announcements? Usually pre-announcements are more negative in nature, as a company looks to get out in front of the news and be proactive to tell Wall Street why they are coming up short on their earnings, and what they plan to do about it. It's about the company seeking to maintain credibility with the Wall Street research analysts. Right now, negative pre-announcements are outpacing positive preannouncements 6-to-1 so far this earnings season. So the big thing to watch with pre-announcements is if the downside reaction can continue as analysts start to cut their estimates. This is where we like to use the After Earnings strategy to potentially ride puts in an evolving downtrend. Special Offer: Be sure to check out my upcoming special offer to get started with my approach to give out specific earnings trades (precise entries and exits) plus commentary on why I did these earnings trades.

16 I call it BigTrends Earnings Explosion - here you will "Learn While You Earn" during earnings season and beyond. Just give us a call at BIGTRENDS ( ) or send an to clientcare@bigtrends.com and we will send you all the details on this alert service.

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