How to trade on earnings effectively with Option

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Once again, even amid this pandemic, we have come to that time of the year where major corporates declare their earnings.While the shock of COVID - 19 seems to have been digested, it seems the India VIX is settling in at least around 30 s and 40 s since past few weeks.

This is definitely not a return to normalcy but it is much better than the 80 s and 90 s seen in the month of March.While amid this super critical source of volatility, we come to the time bracket of the year that brings in rise in stock - specific volatility or better put, rise in Expected Volatility.This in turn makes Options of the stocks going into earnings more and more expensive as the result date nears.

We will talk about two kinds of trades.

-One where we intend to initiate and exit the trade before the result is declared.

-While the other one would be to trade the results with an entry before and an exit after.

As far as the first one is concerned, we know that the expectation of volatility is on a rise.In simple words the premiums of options are fattening without any impact of underlying price.

The figure to gauge this is implied volatility, which could be tracked using a lot of paid and free sources giving information of strike - specific implied volatility.

The figure to constantly track is implied volatility of the strike nearest to the current market price.This strike may very well keep on changing every day or even during the day.Do not worry about that.

The idea behind tracking this number from at least 5 - 7 sessions prior to the result date is to establish the trend that the implied volatility in the result declaring stock is on a rise.

Now, pre - event, a lot of excitement could increase or decrease depending upon the consensus and fear element among participants.In case one feels that there is a possibility of rise in such excitement, which could be very well visible in monitoring the trend in implied volatility then one may Buy both Call and Put with an intention to get rid of them in a day or two but before the event.

This trade also comes in handy when we have a little change in Implied Volatility through the last few days to result.This could be a little out of ordinary so a trade could also be taken for those last few hours before the result as well, betting on the fact that eventually the excitement of unforeseen turn of events would kick in pushing the premiums higher right before the results are declared.

For the second set of trade, a typical result trade where adding up both Call and Put premiums of a strike close to current market price would help with a market gauge of what the maximum expected impact is from the event.

For instance, a 100 CE + PE = 20 with stock @ 100 pre - event, it means the expectation is the stock could see volatility in the range of 80 & 120.

If we feel the outcome of the earnings has capacity to outdo this 20, we would simply Buy both Call & Put and hold on to them through the result declaration.

On the other hand, if the 20 points movement expectation is higher than our expectation then one could also Sell both of them.

Remember, the excitement and the increment in implied volatility is due to the unknown from results / earnings.Once the unknown is out and the result is declared - that excitement dies.

So, many traders especially in the last few hours do initiate the Sell trade on both Call and Put when it is felt that comparatively the increment in implied volatility is unjustified.

But as always since it is an event like any other, while selling both Call and Put do Buy a higher Call and lower Put few strikes away to keep the losses known and finite.

Trading results / earnings could very well be yet another opportunity to make money out of avenues other than regular directional trading, making this a very unique diversification.

(The author is CEO & Head of Research at Quantsapp Private Limited.)

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