For short-term traders, earnings announcements can be an opportunity for big price moves
in either direction-up or down.
But earnings announcements can be unpredictable events-so unpredictable that even seasoned
professionals think short-term trading around earnings is highly speculative and risky.
In fact, many traders avoid trading around earnings altogether.
In this video, you'll learn why the impact of earnings announcements is unpredictable,
how implied volatility changes before and after earnings, and how these implied volatility
changes can affect options prices.
When earnings are announced, they're immediately scrutinized by analysts and compared to previous
estimates.
A stock's price tends to react immediately and sometimes dramatically.
These reactions can occur even before the report is thoroughly examined.
Then, as more information is absorbed, the stock's price may move in several directions
before establishing a clear trend.
Therefore, even if traders can accurately predict the contents of an earnings report,
they may not be able to predict a stock's initial reaction.
This is why it's risky to buy or short stock before earnings.
It's nearly impossible to predict the direction and timing of those moves.
An alternative to directly buying or shorting stock is to consider using options.
An options premium is based in part on implied volatility, which is the market's expectation
of how much a stock could move over the life of an option.
Therefore, implied volatility can factor in large swings that can occur from an earnings
announcement, and prices these swings into the options premium.
But this "pricing in" brings its own risks.
Implied volatility tends to rise in the weeks and days prior to an earnings announcement.
If the market expects the stock price to rise or fall dramatically, implied volatility can
rise significantly.
Implied volatility is closely related to the buying and selling activity in the options
market.
As option traders scramble to position themselves before an earnings announcement, the demand
to use options for protection and speculation grows.
As buying and selling escalates, implied volatility also increases.
After an earnings report is released, the unknown factor driving uncertainty is removed,
so implied volatility tends to drop quickly.
Whether the report is positive or negative, this drop in implied volatility causes an
options premium to decline.
Option traders sometimes refer to this phenomenon as a volatility collapse.
Let's look at a simplified example to learn why this can be problematic for traders.
Suppose an option trader anticipates an upcoming earnings announcement to be very positive
and beat analyst estimates.
As a result, he expects the stock price to rise and buys an in-the-money call option
for $10 the day before earnings, with 10 days until the option expires.
This $10 premium is derived from a complicated formula, but for simplicity, let's say that
$5 is based on the underlying stock price, $2 is for the time left to expiration, and
$3 represents the high implied volatility.
The company announces earnings in line with its estimates and provides an encouraging
outlook for the future quarter.
As a result, the stock price rises.
Each component of the call options price changes.
The portion relating to the stock price rises from $5 to $6, which is a 20% increase.
The portion representing time decreased a little each day the investor owned the contract;
however, it has not changed significantly and is still around $2 because there is still
time remaining until expiration.
And, as expected, implied volatility has collapsed from $3 to $1.
In total, the call is now worth $9.
As you can see in this example, even though the stock price increased, the decrease in
implied volatility caused the options contract to lose money.
This can be a frustrating experience for an option trader.
So whether directly opening stock positions or using options, trading around earnings
announcements can carry significant risks.
Understanding these risks can help you avoid costly mistakes and make informed trading
decisions.