Today's Market Measures segment analyzes theta decay around earnings. We always preach that it is very important to be aware of upcoming earnings announcements when selling premium in individual equities.
The first reason for this is because earnings announcements have the potential to cause large movements in the underlying stock price. As premium sellers, large stock price movements are generally unwanted, unless we are in directional trades and the stock moves in our favor.
The second reason for this is that options generally do not experience normal decay as they do when there are no earnings approaching. The reason for this is that the market will only allow option prices to trade so low when earnings fall within the expiration cycle. This is because the market must price in the expected movement of the underlying after the earnings announcement.
To demonstrate why we avoid selling premium in expiration cycles that include earnings (if we do not want to trade the stock as an earnings play), we looked at some examples of very little decay going into earnings. We looked at AMZN and IBM in the 30-day period prior to recent earnings announcements. Both of these stocks traded in relatively tight ranges, making short strangles an ideal strategy to test.
For the study, we sold 1SD strangles in two different expiration cycles: one cycle that expired prior to earnings, and one cycle that expired after earnings. In the cycle that expired after earnings, the strangle did not decay at all, despite 30 days passing and the stock price remaining stable. On the other hand, the strangle in the expiration cycle that ended before earnings experienced very healthy decay as expected. This proved that options exposed to an earnings move will behave differently than we'd normally expect.
For more on this study, join Tom Sosnoff and Tony Battista as they interpret the results and explain why we avoid selling premium in expiration cycles exposed to earnings (unless we are in the trade as an earnings play).
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