Using Options to Play Earnings News

Last Thursday (4/16/2009) GOOG announced it's  quarterly earnings after the market closed for the day.  Thus, anyone who wanted to make a winning trade by buying options before the news was announced, had to buy those call options (or puts) prior to Thursday's close.

Many investors did just that – as they do when companies announce big news.  That news is most often earnings, but the options of biotechnology companies draw a great deal of attention just before the FDA (or the company) announces news of a drug trial.

Establishing an option position prior to a big new release is a common tactic among option traders.  And it may seem that this is an obvious thing to do.  After all, the news may be unexpected and the stock can easily undergo a large upside or downside move.  And if that happens, you want to own option positions because they have positive gamma.  The simplest way to do that is to buy puts, calls, or both (straddles or strangles).

Sounds like easy money, doesn't it?  Rest assured that it's not.  The major reason that it's not easy money is because you are not the only investor who thinks that buying these options is a smart move. Many traders think that way.  As a consequence, the options of those companies are very actively traded in the days leading up to the news – but the highest volume occurs towards the end of the day – just before news is being released.

When there are many option buyers, you know what happens to the price (premium) of those options, don't you?  Sure you do.  They move higher.  And higher.  Astute traders understand that there's a reasonable price to pay for pre-news release options, and trade accordingly.  They may buy or sell options, depending on the price,  and that price is measured by the option's implied volatility (IV). 

Sometimes the buyers are so determined to own options that they essentially pay any price that's asked of them.  They believe that all options are reasonably priced and if the stock doesn't make the big move they anticipate, they'll be able to unload those options the next day and incur a tiny loss.  And if the stock performs as hoped, they see many dollar bills in their future.  The problem is that they are often wrong on both counts.  If nothing happens, the loses are substantial and too often the gains just aren't there.

This is a trap for less experienced traders, and the purpose of this post is to warn you that buying options before news is not the simple game it appears to be.  It's very risky.  Yes, there is the potential for a big reward, but most of the time the price paid for an option is so high that profits, if any, are far less than the option buyer thought they would be.

If you want to know why, just look at the situation from the point of view of the people who sell most of those options to the hordes of buyers: the market makers.  You make a market in the options and buyers arrive.  You sell some.  Next you sell more.  

OK, you're not stupid, you raise prices, hoping to attract some sellers.  You continue to sell more options – both puts and calls.  You don't want to build a risky position, and you want to hedge the options you are selling.  You need some positive vega and gamma.  The only way to accomplish that is to buy options.  So you raise prices again.  You discover that nothings stops these buyers.  sometimes price move high enough to attract more experienced investors who enter spread orders, relieving the buying pressure for a short time.  Often that helps and an equilibrium is reached.  Buyers and sellers nullify each other and the prices no longer move higher.  But on occasion, the price does not matter, and buyers continue to submit buy orders.   To make a long story short, by the end of the day, prices are very high.

Next morning, the news has been released.  The stock may be substantially higher or lower.   Perhaps the news had little effect on the stock price.  But, one thing is certain – all the option buyers from yesterday (and earlier) want to sell their options.  Some are happy that the stock moved in their direction and hope to nail a very nice profit.  Others were wrong and want to get out before the option becomes worthless.  

Bottom line: lots of sellers and few buyers.  Guess what happens to the implied volatility, and thus, the price of those options.  Pretty easy to guess.  Prices move lower.  And sometimes, even investors who correctly guessed in which direction the stock was going to move are shocked to discover that they lost money.  

So how did GOOG turn out?  The stock issued good news and ran substantially higher, then lower in the after hours.  It was relatively unchanged when the stock opened for trading on Friday.  But, if the owners of long calls sold stock short (as a hedge against their calls) when it traded well above 400, they made out well.  Otherwise, option buyers who waited for the market to open on Friday morning took a hit this time.

But it's not always like that.  Recently DNDN (Dendreon) moved from 4ish to more than 20 in a single day when great news was released.  Call owners were handsomely rewarded.

The point is to be careful.  Most of the time it's better to sell premium – with risk limiting strategies – and that means no naked shorts, than to buy.  Not because the stocks don't move, but because the options are too often overpriced.


8 Responses to Using Options to Play Earnings News

  1. Gil 04/18/2009 at 3:59 PM #

    Since you don’t know for sure how the news will affect the stock, should not it be a good practice to go non directional, buying straddles or stangles (and yes, paying more…)?

  2. Mark Wolfinger 04/18/2009 at 5:13 PM #

    Not in my opinion.
    I believe buying strangles on these stocks – knowing the option prices are pumped – is a death wish.
    If forced to choose, I’d take the other side 100% of the time. Of course, I am not forced and do not have to sell strangles, but I would never buy them.
    I cannot tell you how to manage your risk and which trades suit your comfort zone.
    But most gamblers who take a shot on earnings pick a direction.

  3. Dave 04/19/2009 at 10:39 AM #

    A strategy I’ve recently read about entails buying straddles a few days before big-name earnings (GOOG, INTC etc) then selling for IV profit at the last minute before actual release. I haven’t tried it but seems from this post you might actually “bless” it?
    I read hours everyday mainly to keep abreast of sediment. Your blog earns extreme honor to sit among news feeds and position alerts on my igoogle home page (all other blogs get a lowly favorite tab). Thank you so much for the effort you put into this thing.

  4. Dave 04/19/2009 at 11:18 AM #

    sentiment too 🙂

  5. dave appel 04/19/2009 at 4:56 PM #

    Hi Mark,
    An Iron condor would have worked wonderfully here with Goog. How do you feel about condors to capture the iv implosion ? Obviously if the stock moves to strongly you will relize the max loss. But some of that would be offset by the ridiculously large premuim. Just hoping for your 2 cents on this idea ? Thanks

  6. Mark Wolfinger 04/19/2009 at 5:28 PM #

    Thanks Dave,
    It is a big effort.
    The strategy you mention has some merit – but you must be very careful. This is the type of play that can work well if you have done your homework and have a large amount of statistical data.
    If stock XXX typically has an IV of 35 one week prior to earnings and 45 the day before, you can try your plan. But, I;d want to know that it held true for the specific stock XXX – and more than once. A lot more often than once.
    That said, GOOG declared earnings with one day to trade before expiration. Thus, you would not only have to be certain that IV increases substantailly in a short period of time, but you must consider time decay when expiration is so near.
    If you have the time, willingness, patience, and computer savvy, you can collect a great deal of data and see if this works.
    But this is not a new idea. It’s been publicized previously. I have no idea if it works or not, but have none of the attributes (especially the time or patience) to give this a thorough back test.
    sediment, sentiment….what’s the difference!

  7. Mark Wolfinger 04/19/2009 at 5:33 PM #

    Earnings plays involve risk. Either the stock makes a big move or it doesn’t.
    The one thing that is almost (never say never) certain to happen is that IV gets crushed.
    An iron condor is a good way to bet against the big move. But (I no longer play earnings), I usually prefer diagonal or double diagonal spreads, assuming the options I would buy have an IV that I’d be willing to pay, knowing that an IV crush is coming.
    I usually get more than 2 cents for advice, but I’ll make an exceptiuon this one time.

  8. dave appel 04/19/2009 at 9:54 PM #

    thanks for making the exception on the 2 cents here. 🙂 It isn’t something I tried since I normally do spy spreads but it seemed there may be an edge and predicitng spy vega can be tricky especially in this environment. It is something i am going to try to paper trade though. thanks