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
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
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
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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