How to Trade Earnings With Options

Corporate earnings refers to the quarterly reports that publicly traded companies release that detail their financial performance over the previous three months. These reports provide a comprehensive breakdown of a company’s financial performance, including revenue, expenses, and net income. In the capital markets, these reports are crucial, because they provide transparency into a company’s operations and financial health, offering investors and traders valuable insights into how the business is performing.

Earnings season is the period when most companies release their quarterly earnings reports, and happens four times per year. This season is eagerly anticipated by investors and traders because it’s a time when the market can experience significant volatility. A company’s earnings report can trigger sharp movements in a company’s underlying stock price, depending on whether the results meet, exceed, or fall short of expectations. During earnings season, the stock market often reacts quickly, with prices jumping or dropping based on the latest earnings news.

Earnings are critical because they play a significant role in shaping how a company is perceived by the market. Strong earnings typically signal that a company is performing well, often driving up stock prices as investor confidence in the company’s future prospects grows. Conversely, weak earnings can indicate underlying issues, potentially leading to a decline in stock prices as investors reassess the company’s outlook. 

For participants in the options market, earnings season is particularly enticing, because options prices (aka implied volatility) can shift dramatically leading up to an earnings event, and in the aftermath, creating numerous opportunities for strategic positioning. 

Earnings reports provide critical updates on a company’s financial health, which can lead to dramatic moves in the underlying stock. As a result, investors and traders are particularly active during earnings season because it is a time of heightened market activity and opportunity. 

For long-term investors, earnings season is important because it provides a glimpse into a company’s ongoing performance and prospects. Positive earnings can confirm the strength of those investments, prompting long-term investors to hold, or even increase, their stakes. Conversely, disappointing earnings may prompt a reassessment, potentially leading to adjustments, or even divestments.

For traders, particularly those focused on options strategies, earnings season is attractive because of the volatility it generates. Stocks sometimes experience sharp price movements immediately before, and after, earnings announcements, providing the opportunity for compelling trades. Of course, one must also recognize that the potential for big moves can also translate to increased risk. 

Overall, the steady release of key financial information during earnings season can significantly impact the stock market and the broader financial landscape, which is why it is watched so closely. The dynamic nature of earnings season also allows for the deployment of a broader range of strategies, further enhancing its appeal.

When reading an earnings report, it’s important to understand that this information provides a detailed look into a company’s financial health and operational performance over a specific period, usually a quarter. 

Investors and traders typically use earnings reports to gauge how well a company is doing, how it compares to past performance, and what the future might hold. While earnings reports can be lengthy, investors and traders usually focus on key areas of interest, which can provide critical insight into a company’s overall operations, and assist with informed decision-making. 

Some of the key data points that investors and traders typically focus on in an earnings report are outlined below:

• Revenue: The total money the company brought in during the quarter, which is a direct indicator of sales and growth.

• Net Income: The profit remaining after all expenses are deducted from revenue. This provides insight into a company’s ability to profit from its revenue. 

• Earnings Per Share (EPS): This metric divides net income by the number of outstanding shares, giving investors an idea of how much profit is attributed to each share.

• Operating Cash Flow: The cash generated from the company’s core operations. Positive cash flow can be an indicator that a business is performing well. 

• Gross Margin: The percentage of revenue that exceeds the cost of goods sold, reflecting the efficiency of production or service delivery.

• Operating Margin: The percentage of revenue left after covering operating expenses, indicating overall operational efficiency.

• Debt-Related Data: A look at how much debt the company is carrying. High debt can be risky, especially if earnings are under pressure.

• Forward Guidance: Financial forecasts provided by the company for the upcoming quarter or year. This information can be extremely influential for the company’s underlying shares, due to associated insights into a company’s future prospects. 

• Earnings Surprises: Comparing actual results with analysts’ expectations. Significant beats or misses (aka surprises) can trigger sharp movements in a company’s underlying shares. 

• Comparison to Peers (Competitors): How the company’s performance stacks up against its industry peers. This can highlight competitive strengths or weaknesses.

Investors and traders often take a strategic approach to prepare for earnings season, because it can be a time of significant market volatility and opportunity. Some of the more common preparation methods are outlined below:

• Research Historical Performance: Review past earnings reports to identify trends and to consider potential outcomes.

• Analyze Analyst Estimates: Compare expected earnings with historical data and market conditions to assess the likelihood of meeting or missing expectations.

• Monitor Market Sentiment: Keep an eye on recent news, company announcements, and industry trends to gauge market expectations and sentiment. 

• Set Price Targets: Establish potential entry and exit points based on different earnings scenarios—positive, neutral, or negative. Then update those entry/exit points based on new information and developments. 

• Manage Risk: Consider using stop-loss and/or take-profit orders to limit losses and to lock in gains. 

• Adjust Position Sizes: Tailor the size of your investment based on your confidence in the earnings outcome to manage risk. Considering that high-magnitude moves can develop during earnings season, it may be prudent to scale back and trade small. 

• Diversify Investments: Spread investments across multiple stocks or sectors to mitigate risk during earnings season, similar to other periods of the year. 

• Prepare for Post-Earnings Moves: Anticipate and plan for continued stock movement after the earnings report is released. 

• Reassess After Earnings: Reevaluate your individual positions and overall portfolio based on the new information released during earnings season, including the market’s reaction.

During earnings season, options can be a powerful tool for traders looking to capitalize on the uncertainty surrounding a company’s earnings release. At a high level, this is because options are very dynamic, and can accommodate a wide range of market outlooks. However, earnings season is unique because options prices can shift dramatically leading up to - and after - an earnings event.

For example, as an earnings date approaches, the prices of options (reflected in their implied volatility) tend to inflate. This rise in options prices is driven by the uncertainty of the earnings outcome, because if a company exceeds or misses expectations, it may lead to a dramatic move in the underlying stock. As a result, some market participants are willing to pay a premium for options that might benefit from these potential swings.

However, once the earnings report becomes public, some of the uncertainty usually resolves itself, and options prices often deflate—a phenomenon referred to as an "earnings crush." During the crush, implied volatility typically declines, because the major event (e.g. the earnings announcement) has passed, reducing the likelihood of a large, unpredictable move. The earnings crush is usually observed in the expiration cycles (weekly and monthly) that capture the earnings event. 

Importantly, earnings season tends to draw in a higher number of investors and traders, due to the potential for big moves in the options markets during an earnings event. On top of the above, the options market can accommodate a wide range of market outlooks, and that flexibility is also attractive to many market participants. 

For example, if an options investor expects a stock to move more than the market anticipates, he/she might purchase a straddle or strangle, which are designed to profit from high-magnitude moves in either direction. On the other hand, if an options trader expects the underlying stock to move less than expected, he/she might decide to sell a straddle or strangle, aiming to profit from the post-earnings options crush. 

It’s important to recognize that risks are also heightened during earnings season, due the unpredictable nature of the earnings reports. From this perspective, it’s critical that investors and traders have a deep understanding of the potential risks and rewards associated with any options position they might be considering. And that’s true any time of the year, not just during earnings season. 

Options trading can be a complex endeavor, making it essential for investors and traders to fully understand both the mechanics of options, as well as the associated risks, before transitioning to live trading. 

Starting with mock trading (also known as paper trading) is often a wise approach, as it allows one to gain experience and observe how options behave in different market conditions. This practice helps develop the necessary skills and confidence without the risk of capital losses. 

Once comfortable with options trading, investors and traders can explore a wide range of strategies. These strategies might be designed to profit from a larger-than-expected move in the underlying stock, a smaller-than-expected move, or a variety of other scenarios. 

Options participants deploy a wide range of positions during earnings season, much as they would any other time of the year. But there are some strategies that see increased interest during earnings season, which are outlined below. 

Long Straddle/Strangle

• Structure: Buy a call option and a put option at the same (straddle) or different (strangle) strike prices with the same expiration date.

• Preferred Outcome: Usually benefits from large price movements in either direction, typically when a trader expects the stock to move significantly more than the market anticipates, but is uncertain about the direction.

Short Straddle/Strangle

• Structure: Sell a call option and a put option at the same (straddle) or different (strangle) strike prices with the same expiration date.

• Preferred Outcome: Usually benefits when the stock moves less than expected, allowing the trader to collect the premium from one (or both) options when they expire. This strategy is typically used when a trader expects minimal price movement and aims to take advantage of inflated options prices (aka implied volatility) before an earnings event. 

Long Calendar Spread

• Structure: Buy a longer-term option and sell a shorter-term option at the same strike price. This usually involves the nearest monthly expiration period, and the one immediately after - though that’s not always the case. 

• Preferred Outcome: Usually benefits from the “volatility crush” after an earnings event. Often performs best when the stock stays near the strike price, because the shorter-term option will lose value faster than the longer-term option, allowing the trader to potentially buy it back for less.

Learn more about calendar spreads.

Covered Call

• Structure: Own the underlying stock and sell an upside call option against it.

• Preferred Outcome: This approach can generate additional income (from the short call premium), assuming the stock trades sideways, or rises slightly, in the wake of the earnings event. This strategy also limits the potential upside of the long stock position, but also provides a cushion in the event of a selloff.

Learn more about covered calls.