Earnings Season Begins This Week … A Quick Glance at a Potential Trade

Citigroup-earnings-trade-iron-condor

This week starts the beginning of another round of earnings.

The big banks start of the earnings season with JP Morgan Chase (JPM), Citigroup (C) and Wells Fargo (WFC) leading the charge.

As always, I will be posting frequent trades during earnings season so check on the site from time to time for any updates. Also, I will be sending out my weekly “Top Earnings Options Plays” every Saturday throughout the earnings season, so stay tuned!

My approach to earnings is quite simple. I’m not trying to guess the direction of a stock after an announcement.

I’m simply taking a statistical approach.

Because every earnings announcement comes with uncertainty, and with that uncertainty comes heightened implied volatility as investors are either speculating to some degree or simply hedging their position. This is fact. Regardless, the increase in demand for options contracts leads to an increase in that underlying stock’s options prices, particularly during the week of the announcement.

I’m simply trying to find the best opportunities that the market has to offer during each earnings season and place statistically based trades on those that look the most promising.

The strategy is highly dependent on taking a quant-based approach. Again, focusing on the probabilities and allowing the law of large numbers to work its magic. But more importantly, we should have a clear understanding of how to manage sequence risk when using a high-probability approach. I’ll be discussing all of this as we move through this earnings season.

One of Several Key Strategies to Trading Earnings

Iron condors are one, among several, of my go-to options strategies for trading around an earnings announcement.

The basic premise of the iron condor strategy is simple; choose a range that is typically outside of the expected move. Increasing the range will decrease your potential profits but will increase your probabilities of success.

As always, we only want to trade using highly liquid securities. I provide a screen of the most highly liquid stocks every week during earnings season, which includes extensive research on each trade, including a screen for the best strategy to use.

For instance, take the heavily traded Citigroup (C). The company reports earnings before the opening bell Friday, and I’m curious how implied volatility looks for next week’s expiration cycle and the subsequent options prices.

I typically place earnings trades the day earnings are announced, if released after the close, and the day before, if released prior to the opening bell the next trading day. But I like to scout out trades prior just to see how the premium looks when the time comes to potentially place a trade. I hope the following exercise helps to demonstrate my quantitative approach to earnings.

The stock is currently trading for 65.70.

citigroup-stock-chart-january-10

As soon as earnings pass, implied volatility (IV) is crushed, so we want to take advantage of the short-term heightened levels. Again, inflated volatility is one of the key components to making this a successful, long-term strategy which is why IV rank and IV percentile are key screens in finding the best stocks to trade. (I post this on the most notable earnings announcements every Friday during every earnings season.)

An above-average to extremely high IV rank simply tells us that we can sell options for fair-to-highly-inflated prices. And as anyone who has sold something knows, your preference is to always sell your product(s) for inflated prices. Options are no different.

Next, I like to take a historical look at prior earnings announcements for the stock I’m interested in trading. Going all the way back to 2006, the average move in Citigroup is roughly 0.5% with anomalies sitting just above 10% and below a 6% move. Knowing how a stock responds around earnings gives me insight into how to approach the trade, or to simply avoid a trade altogether.

historical-earnings-reactions-Citigroup-C

Now we need to find the expected move or expected range for our chosen expiration cycle. In most cases, we use the expiration cycle that is one to nine days after the earnings announcement. We chose the expiration with four days left for our C trade.

The expected move for C is roughly +/- $2. There are several trading platforms that offer the expected move, I have found that Tastyworks, at least from a visual standpoint, offers the best information on expected moves.

expected-move-citigroup-c

Because we know the expected move, we have the ability to choose strikes outside of that area.

First, I look at the call side of the iron condor, also known as a bear call spread. I want to find a short call strike with around an 80% probability of success, if possible.

The January 14, 2022, 69 calls fit the bill. It has a delta of 0.17 and a probability of success of 86.40%. The probability that C will touch the 69 call strike at expiration is 31.31%.

citigroup-bear-call-spread-earnings-trade

Once I’ve chosen my bear call spread, I look towards the put side, for my bull put spread, with the same goal in mind: a probability of success around 80% or higher.

citigroup-c-bull-put-spread-earnings

The January 14, 2022, 63 strike put works. It has a probability of success around 80.55% and a delta of 0.18. The probability of touch stands at 38.23%.

So, my starting range is from 63 to 69. Obviously, I could have used different strikes, but this is the typical starting point for my iron condor trades around earnings. Once I know my potential return at around the 80% probability of success level, I can alter my range accordingly.

What’s the Return?

If I sell, say, the 69/72 bear call spread and the 63/60 bull put spread simultaneously, thereby creating an iron condor position, I have the ability to bring in roughly $0.42, for a potential max return of 16.3%.

citigroup-iron-condor-earnings

Because we are using 3-wide strikes (63/60 and 69/72), our risk is $2.58 per iron condor (width of spread strikes minus amount of premium received or $3 – $0.42).

With C trading at roughly 65.70, the breakeven levels are 69.42 to the upside and 62.58 to the downside. Again, the probability of success on the trade is 80.55% at the 63 put strike and 84.60% at the 69 call strike. Our breakeven probabilities are even greater.

I like those odds.

Remember, it’s all about taking advantage of the law of large numbers and the IV crush that is inherent in each and every earnings trade. Once you move away from the mechanics of the trade, you’re allowing emotions to seep into your decision making, and that is what we all want to avoid.

Risk Management – Don’t Overlook the Importance of Position Size

Because we are making short-term trades based purely on binary events, risk management as seen through strict position size is essential for long-term success. In fact, since the trades have little to no duration, there is rarely time to adjust a trade, therefore, again, position size is key.

We know through extensive research that roughly 80% of the expected move around earnings is larger than the actual movement of the stock.

Remember, we are trading math here. It’s all about allowing the probabilities to work themselves out, knowing that if the law of large numbers play out, our wins should far outweigh our losses. So, keeping our risk at reasonable levels is of the utmost importance.

There is so much more minutiae that occurs during an earnings season play. As a result, I will be including several videos on the site and some live sessions to go over the different scenarios one might face when trading earnings.

Again, if you have any questions, please feel free to email me or post your question in the comments section below. And don’t forget to sign up for my Free Weekly Newsletter for weekly education, research and trade ideas.

4 comments on “Earnings Season Begins This Week … A Quick Glance at a Potential Trade

    • Andy Crowder on

      Walker,

      Thanks so much for the kind words. Hoping you will continue to find the site helpful in all your trading endeavors.

      Reply

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