The Worst Way to Play Tech Earnings

We're in the midst of a rather volatile tech earnings season, which can present opportunities for some investors that feel strongly that a stock might pop or plunge after an earnings release.

So far, we've already seen names like Riverbed Technology get punished by 29% after reporting a lackluster quarter. In contrast, fellow networker F5 Networks (Nasdaq: FFIV  ) stood and delivered a strong quarter, sending shares upward by 11%.

If you have a stance on how a company might fare going into earnings, there are various ways to play. The simplest is to go long or short the stock accordingly, but more adventurous investors might look to options, which aren't for the faint of heart. When it comes to trading options during earnings, there's decidedly a way that you shouldn't be playing.

All options traders need to know this -- no exceptions
This applies outside the realms of the tech sector, but the sector has some great examples. The most basic strategy is to buy a call if you're bullish or buy a put when you're bearish. This is deceptively simple, as novice options traders are apt to get burned by the most important aspect of option pricing: implied volatility.

Implied volatility, or IV, represents how much volatility the options market -- specifically, option market makers -- is pricing into option contracts. The more volatility that's expected (implied), the higher the option price -- all else equal. This applies to both calls and puts. The timing of earnings releases is known in advance, so the market begins pricing in potentially big moves leading up to the release, meaning that option prices across the board begin to rise.

As soon as the figures are released, IV will fall, along with options prices (all else equal). I view IV as a proxy for the relative level of overall prices, based on what the options market is expecting. Sophisticated options traders will trade only volatility through a process called "gamma scalping," but the mechanics of that strategy are beyond the scope of this article.

After earnings, IV will fall, no matter what. So if you buy an option going into earnings, you're betting that the stock will move enough in your favor to offset the inevitable fall in price related to the IV drop.

Examples galore
The Chicago Board of Options Exchange provides volatility tools, including free charts of IV. Here's how Google's implied volatility looked when it reported earlier this month, along with its new voting structure. Google is no stranger to volatility, and that shows in its option pricing.

Source: CBOE.com, powered by IVolatility.com. Emphasis and ticker label added.

Focus on the brown line, which represents overall IV. The blue line represents 30-day historical volatility derived from actual price activity. I've marked the earnings dates in red, and you can see how it plunges after earnings every time without fail, which decreases all option prices.

The timeless adage of "buy low, sell high" also applies to IV. If you purchase an option just before earnings, you are buying IV high, and you will be selling IV low if you then close out your position shortly after.

Here's how F5 looked.

Source: CBOE.com, powered by IVolatility.com. Emphasis and ticker label added.

Apple (Nasdaq: AAPL  ) saw a higher IV rise than normal, as there was concern that it would miss on iPhone targets due to data from domestic carriers, in addition to the incredible rally it's had year to date.

Source: CBOE.com, powered by IVolatility.com. Emphasis and ticker label added.

It ain't over yet
Earnings season isn't over, and some reports next week should be big movers. Acme Packet (Nasdaq: APKT  ) reports on May 2, and Nuance Communications (Nasdaq: NUAN  ) is scheduled for May 10. Both companies are seeing their IV figures rise as we approach those dates.

Acme Packet's had a rough couple of quarters due to order delays at carrier customers. We'll see if it can book the big deals that it's been promising.

Source: CBOE.com, powered by IVolatility.com. Emphasis and ticker label added.

Nuance's relationship with Apple remains ambiguous, and it got crushed last quarter on concerns of how it's monetizing its speech engine that powers Siri. Hopefully this quarter will shed some light on how much revenue upside Nuance can enjoy from the partnership.

Source: CBOE.com, powered by IVolatility.com. Emphasis and ticker label added.

What's a Foolish options trader to do?
That's not to say that simply buying a call or put going into earnings can't be profitable, but rather it's much more difficult than you probably think. If the stock moves in your favor, there are two conflicting forces: the IV-driven decrease and the price-driven increase. You're hoping the latter outweighs the former.

I've learned this the hard way. In the past, I've bought a call going into Apple earnings, expecting a blowout. Apple reported a blowout as usual, shares jumped, and I lost money. The IV drop was particularly brutal when the stock didn't rally enough. This is why long options are one of the worst ways to play earnings.

You wouldn't buy a stock that you knew for a fact would drop the next day, so why would you buy an option knowing its IV will fall?

There are other ways, albeit with different risks. You can go long an option well in advance of earnings, before IV begins to rise (buy IV low), and sell right before earnings are announced (sell IV high). Obviously, the stock can move for or against you in the meantime, which is the primary risk here.

Secondly, you could sell an option right before earnings (sell IV high), and buy it back after earnings (buy IV low). Again, the big risk here is that the stock can still move against you based on the results.

Naturally, there's always some type of risk, especially when we're talking about options. The takeaway here is that understanding IV better will help you understand your risks better, which makes you a better investor. Another lesson is that if a strategy with options seems too good to be true, it probably is.

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Fool contributor Evan Niu used to be a senior trading specialist at Charles Schwab that specialized in constructing options strategies with high-net-worth clients. He owns shares of Apple, Nuance Communications, and Riverbed Technology, but he holds no other position in any company mentioned. Click here to see his holdings and a short bio. The Motley Fool owns shares of Google and Riverbed Technology. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Google, Apple, Acme Packet, Riverbed Technology, and Nuance Communications. Motley Fool newsletter services have recommended writing covered calls on Riverbed Technology. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. The Motley Fool has a disclosure policy.
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Read/Post Comments (6) | Recommend This Article (30)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 26, 2012, at 6:03 PM, Vismxr wrote:

    Yes Obewon be careful. I'm a 75% investor like Munger taught me. But I like trading 25%. I buy into earnings and bought a straddle on Riverbed. A call & put same strike just before earnings. After earnings my call was a 100% loss and my put was a 485% gain.

  • Report this Comment On April 26, 2012, at 7:14 PM, beastofbodmin wrote:

    Indeed. Selling puts if bullish and calls if bearish puts IV on your side.

  • Report this Comment On April 26, 2012, at 10:30 PM, slof1955 wrote:

    Speaking of tech, any comments on WPRT?

  • Report this Comment On April 26, 2012, at 11:14 PM, rck329 wrote:

    Thank you for this post! I only wish I had figured this out earlier. Getting burned on Apple May calls I bought before earnings. Unfortunately, I also bought some of them before the underlying got beat all the way down to the 550's, so even the pop couldn't get me back to even.

    So the question now is do I hold them into next week to hope to regain some if it starts to rise?

    Do you think the stock is being held down now till the weeklies expire?

  • Report this Comment On April 27, 2012, at 12:59 AM, petrogold wrote:

    From my instinct I have been doing it. But how to deal in market where no option trading is in practice. I did buy stock before realising earnings & found some gone high before AGM/Record Date while others did not. I sold one stock (Foot Wear) just next day of Record Date and found it went higher and higher next few weeks. Usually all other stocks fall after earnings declared.

  • Report this Comment On April 29, 2012, at 8:30 PM, gmc0652 wrote:

    The reason I use options should be obvious. It's called leverage. I simply cannot afford to buy a meaningful number of shares of Apple, but I can afford call options, even at elevated IV prices.

    There are ways to lessen the impact of IV losses.

    First, buy the options several weeks before earnings. I did this with Amazon, and because IV increased in the following weeks I was able to make money even BEFORE earnings, although the stock price was fairly stable

    .

    Second, you can buy options with expirations further out. My options with Amazon were July expirations. The time value will counter IV changes to a certain extent.

    Finally, to counter directional risk, do as I and Vismxr above did. Use straddles or some other combination of options

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