Trading Options During Earnings

Are you learning the hard way
how much earnings affect option prices? A good example is Cisco
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which reported earnings on Monday night after the close. During the day on
Monday, volatility for November options was 90 and volatility for December
options was 70. On Tuesday, after the Cisco earnings had been announced
Monday night, November volatility had dropped to 60 and December to 58.

Do you find yourself wondering “How does this affect my trading and how can
I take advantage of this?” If so, keep on reading.

First of all, the above scenario with Cisco is pretty normal for a stock during
earnings. With the stock at 55 on Tuesday (after earnings), Call buyers in
November options lost 1 1/4 with the stock unchanged. Straddle buyers got
tortured! A straddle in November went from 7 to 4 1/2 for 55 strike.

Here are some earnings rules that my traders and I looked at with CSCO:

  • The time to buy Calls,
    Straddles, or Ratio Call Spreads is three weeks before earnings — while
    volatilities are still reasonable.

  • Here’s a Big Secret: The
    beauty of buying options three weeks before earnings is that your time decay
    will be small. Earnings expectations will keep your options from
    decaying like they normally would.

  • Don’t start drooling simply
    because December in CSCO was 20 points cheaper than November. Twenty points in November volatility is the same as 10 points in December. In
    Cisco it was 3/4.

  • Sell out of at least 50% of
    your long Calls the day before the earnings are released. Remember,
    if the stock goes up $2 1/2 after earnings, the calls will probably remain
    the same, due to the fact that volatility will get smashed.

Let’s look ahead at Hewlett-Packard
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, which has earnings next week. This week alone saw option
volatilities up 38 points in November and 9 points in December. What that
means for Call buyers is that a November 40 Call is up from 2 1/8 to 3 — with
the stock remaining unchanged at 40! We would be looking to get out of at
least 50% of our long options in HWP one day before earnings.

Also keep in mind that due to the fact that HWP earnings are near November
option expiration, the premium in the options will be much less than if the
earnings were three weeks before expiration. When earnings fall the week of
expiration, we determine if we think that the stock might see a 15% or higher
move as a result of earnings. If we do, we will look to buy calls, puts or
straddles on the day before earnings are announced.

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