Earnings reports mean a lot to an options investor. In fact, they’re kind of our specialty around here.
Figuring out exactly how and why… that’s one of the ways to set your personal portfolio apart from the pack. Now, this is a subject bigger than one post can handle, but here’s what you’ll need to know to get started. (Note: This subject may get a little wonky. Don’t be afraid to follow the links if you need some explanations!)
What are quarterly earnings?
Once per fiscal quarter, publicly-held companies announce their after-tax profits for the previous three months. Although this report contains a lot of information, the headline number is the earnings per share (how much money the company made per stock held) and how that number compared with predictions.
That relationship matters quite a lot. Whenever you see headlines about how a company’s profits failed to meet expectations, it means that the company reported quarterly earnings judged to be too low even if they still made a profit.
Why does this matter?
Earnings reports have an enormous impact on the marketplace. They contain information about corporate health, trend lines, and what to expect in the future.
What you do with that information will depend on whether you’re following a long or short term investment strategy. (Here are some ideas to pursue…)
Short Term Traders: Take the volatility crush
The lead up to a quarterly earnings report is generally defined by a period of high volatility for stock options.
Unsure of what will happen on earnings day traders speculate and make predictions, which leads to large swings in the price of the underlying. In fact, one study found that the 40 most volatile S&P 500 stocks move within a range of 6.2 percent by their earnings day. This results in what’s called “implied volatility,” the measure of how options traders build stock volatility into their contract and premium estimates.
Once earnings are announced, the volatility smooths out. (There’s no more need to guess about upcoming information.) It’s called the “volatility crush,” when traders stop speculating and the stock movement returns to normal.
For short-term traders, this creates a window of opportunity to sell contracts, since premiums will rise as implied volatility pushes extrinsic values up. In the alternative, for options purchasers, the days leading up to a volatility crush can be an excellent time to buy as the underlying stock jitters around your strike price.
Either way, it’s a short term window of opportunity in which options contracts can get a lot more valuable (or a lot more expensive).
Long Term Traders: Find the curve.
For long term traders, each quarterly report is part of a continuum. Looking at the earnings per share, following how those have changed over time and comparing it all to how the company did against expectations creates an invaluable set of data for projecting how the underlying stock will perform in the future.
In particular, long-term traders should compare the asset performance against expectations; after all, a stock price is largely based on how confident the market feels about a company. Even a high-value business will lose value if it keeps disappointing its investors. (A good sign you might want to pick up a put position, regardless of the stock’s actual value.)
And ultimately that’s the key to long term options trading: what will the market think of this stock far enough down the line?
The best place to start is by looking at what the market thinks of that stock today, and how that has changed over the past several quarters.