Trading Options around Earnings

in this video we're going to take a look at an application of options trading specifically what we're going to look at is trading around earnings announcements this is something that a lot of beginning option traders will want to do because there's a big event coming up and they think they can hit the homerun on options sometimes they will but there's one thing you've got to really be careful for and that's what we're gonna try to illustrate here so let's start with a scenario you decide you want to trade options around earnings announcements try to capture that big event so you're looking at a company that's going to announce earnings after the close let's say it's Wednesday afternoon getting close to the closing bell and you know a company is going to make their earnings announcement right after the markets closed you want to make your big bet if you think earnings are going to be better than expected you want to purchase a call option remember a call option gives you the right but not the obligation to buy the underlying stock so if the stock price shoots up dramatically you've got the right to buy it for that fixed price the strike price of your option on the other hand if you think the earnings are going to be worse than expected that they're gonna miss you don't want the right to buy it you want the right to sell it so that's going to be a put what's going to give you the right to sell the underlying stock for a fixed price and that way if the stock tanks you can sell it at the strike price and make a profit another possible scenario is you don't know what earnings are going to do you just know that this is going to be a big earnings event maybe the company does much better than expected maybe the company does much worse than expected well you might decide to buy a straddle a straddle means you buy a call contract and a put contract both the same strike price and here what you're betting for is that the stock price is going to move so much you know you're going to lose on one of these but you're hoping that the stock price goes up enough you can make more on the call then you lose on the put or the stock price goes down enough that you'll make more on the put then you lose on the call so a straddle is a you take if you think there's going to be a big swing in the stock price but you don't know which way it's going to move now one thing I like to do is sometimes take finance outside of the textbook a little bit and try to make sure we apply it into a real-world scenario so here we're going to look at an example using real data from July 19th and 20th 2011 and this deals with Apple's third quarter report earnings reports so Apple is reporting on July 19th after the bell so if we look at the July 19th closing prices the stock was trading through three hundred seventy six dollars and 85 cents the August three eighty call was trading for twelve dollars and fifteen cents the August three eighty foot was trading for 1550 now the reason we're looking at August here is that they're the near-term options and so if we want to buy at this point the July options are already expired so if we want to buy the nearest term option to make a bet on earnings we're going to use these August options so the August 380 call August 380 put are close to the current stock price these are near the money contracts that's what we're going to use to make our bets on which way they are which way the earnings report is going to go now heading into earnings analysts were expecting earnings per share of 5 dollars and 85 cents for the quarter and revenues of just under 25 billion dollars for the quarter so these are our baseline numbers if you think apples going to do much better than expected maybe earn 7 dollars a share you want to buy the call because you think that's going to really push the stock price up a better than expected report tends to push earning or push the stock price up on the other hand if you think maybe Apple only is going to earn 5 dollars and 50 cents and come in worse than expected you're probably going to see a big sell-off in the stock price the next day so then you'd want to buy the put if you don't know which way Apple is going to go you think that this is going be a big earnings event may be much better than expected may be much worse than expected you might decide by both by the call and put and hope one of these turns into enough of a homerun to offset the other so now let's look at kind of a prediction what do we think might happen in order to start this we have to go back to the idea of what determines the value of an option option prices are a function of the current stock price strike price the risk-free rate of interest time to expiration and the underlying volatility of the stock at any given point in time we know four of those five variables we know what the current stock price is in our example heading into the clothes it was three hundred seventy six dollars and eighty five cents we know the strike price in our example that was a three hundred and eighty dollar strike price the risk-free rate rino now I'm going to use a one percent risk-free rate in this example in reality it's probably closer to zero percent right now during the time I'm recording this for an exceptionally low short-term interest rates but it's not going to make a big difference in our analysis so I just picked one percent time to expiration going into the July 19th close right before the earnings announcement when we need to establish our position there were 31 trading days remaining and so the one missing variable we don't know is the implied volatility what are investors assuming is the volatility however if we look at the option prices which we do know we know the July 380 call is trading for twelve dollars and fifteen cents July I mean the August 380 call for 1215 and the August 380 put is trading for 1550 so we know the prices of those options we know the time the risk-free rate current stock price we know the strike price we can go ahead and count callate the implied volatility using the black-scholes option pricing model now I didn't do that in this video to show you but I actually did do it using a spreadsheet I've set up with the black-scholes option pricing model and there was a lot implied volatility of about thirty one and a half percent so given that now we could do some what-if analysis if Apple went 360 then this is what should happen so this is the big miss Apple turns in a weaker than expected earnings report stock price drops from three hundred seventy six dollars and 85 cents all the way down to three sixty by the next day's closed so July nineteenth earnings announcements come out after the markets closed let's say the closed on July 20 is 360 according to the black Scholes option pricing model that means the value of the call should dropped five dollars and seventy two cents the value of the push should go up remember a put is a bet on the stock price declining so that should jump up all the way to twenty five dollars and forty one cents flip side is what if Apple does better than expected the Apple goes to 390 and beat earnings expectations stock price jumps up the call probably will climb to around nineteen dollars and sixty two cents are 931 so what we're doing here is using the black Scholes model to make some predictions of what might happen to get an idea of how profitable these options positions are going to be now let's take a look at what happened Apple blew out the quarter they they didn't just beat earnings expectations they nailed it their actual earnings per share was seven dollars and 79 cents and revenues were twenty eight and a half billion give you an idea remember the expected earnings was 585 so they did almost $2 a share better and the expected revenues were about twenty five billion so they ended up with over three and a half Billy dollars more in revenues great quarter for Apple stock price went up the next day the close on the 20th the next day's close was 387 twenty nine stock went up ten dollars and forty four cents now that may seem like not that big of a move for how much better earnings were than expected but two things go on here one Apple has a history of beating analyst expectations so really expected earnings or below expected earnings that doesn't sound like it makes sense but what's going on is investors more or less expect Apple to beat the earnings estimates by a little bit so a little B is not considered a beat at all however this wasn't a little bit nobody expected numbers like this so why did it only go up $10 a share the answer is stock price reaction is based not just on what happened the last quarter but also what the outlook was and Apple didn't get near as exciting of an outlook for the next quarter as the results for this quarter it was still good but not like what we would have expected given those results from the last quarter so the stock price went up the three eighty seven twenty nine an increase of ten dollars and forty four cents now again based on the black Scholes option pricing model if we plug in values 30 days remaining one percent risk free rate stock price of 387 twenty nine and what is the value of the call what is the value of the put the black Scholes option pricing model tells us that the call should go to seventeen ninety-four in this scenario the put should go to ten dollars and thirty four cents so remember our three potential trades that we talked about one was rethought earnings were going to beat expectations we bought the call if we did that remember it cost us 1215 when we bought call contract one contract is for 100 option so we just take 100 times the per option price was going to cost this 12:15 the option went up to 1794 that's going to give us a profit of five hundred and seventy nine dollars so our expectation given these results were if we bought the caller's should have made five hundred seventy nine dollars what about if we bought the put yeah that wasn't too good right because the put is a bet that the stock price is going to go down it went up put should go to ten thirty four repaid 1554 it so ten thirty four is the ending value fifteen fifty is what really paid that results in a loss of five hundred and sixteen dollars that's what we've got here so if we would have purchased the put based on this earnings we should lose five hundred sixteen if we did the straddle remember the straddle means we bought a call and we bought a put so our net profit is sixty three dollars wasn't a huge move but it was big enough that our straddle should have made money now remember these aren't the actual closing prices on the 20th these are what we predicted would happen given a stock price of 387 twenty nine so this is an actual stock price these are predicted based on this stock price and the black-scholes option pricing model how well did those predictions fold up here's what actually happened the 380 call went to 1435 wait a minute he said it was supposed to go to 1794 why did it only go to fourteen thirty five and the put went to seven thirty we thought it was going to go to ten thirty four is the black-scholes option pricing model that screwed up doesn't seem like it it's one of the more famous contributions in finance it shouldn't be that far off but let's what actually happened we anticipated that if Apple stock price went to 380 729 which it did we should have made five hundred seventy nine dollars we actually only made $220 if we bought the put we were predicting were to take a loss of 516 we lost 820 and our straddle which we thought would be profitable actually turned out to cost us $600 so obviously something's screwed up here the black Scholes option pricing model seems to have really messed us up and trying to implement this trading around earnings has not worked out as well as plan so what went wrong well it wasn't the black Scholes option pricing model that went wrong it was we weren't really thinking remember one of the key factors that drives drives option prices is volatility volatility is kind of how much unpredictability is there in the stock price how much is the stock price going to bounce around while prior to earnings implied volatility is high investors don't know what's going to happen just like we didn't know what was going to happen so everybody is building in a high volatility and after earnings that volatility is going to decline now we know more information there's less unpredictability so the implied volatility declines looking at the black Scholes option pricing model in calculating implied volatility this is exactly what happened the implied volatility dropped from about thirty one and a half percent prior to earnings two twenty four percent right after earnings what that means is that drop in implied volatility is going to hurt the value of the call and the value of the play and that's why we did much worse than Rhian tissa paid it so if you're trading options and you get the idea well there's a big event coming up you have to remember everybody knows there's a big event coming up so prior to that event you're going to have higher implied volatility your options or be more expensive after the big event that implied volatility is going to come down your options are going to be cheaper does it mean you can't make money by buying calls or buying puts prior to an earnings announcement it just means that you're going to have a lot higher target to hit because that implied volatility is going to move against you so buying call options buying put options just buying straddles right before earnings expectations is a lot tougher game than it looks like because you already have that strike against you when you know implied volatility is going to decline what you might want to do and I'm not advocating this as a strategy to use all the time but to alert this in your favor you can sell options right before earnings announcements now the advantage in our scenario here if you would have just sold the call you would have still lost this 220 if you would have sold the put remember these were profits on buying so if you sell them you've got to flip the signs around if you sold the put you would have made eight hundred and twenty dollars if you sold the straddle you would have ended up making six hundred dollars so sometimes you'll see people end up selling options prior to earnings expectations or some other big event like maybe an FDA announcement for a pharmaceutical company anything along those lines that can have a big movement in the stock price and the reason they sell those options is they know that implied volatility is going to decline so if the big event is not quite as big or important as people thought it might have been they might make a big profit on their options this gives you just a little example of some of the things you have to think about when trading options it's not just about what the stock price is going to do it's also what volatility is going to do that's going to impact your profits or losses on your trade hope this video has helped thank you

Channel: Kevin Bracker

Views: 19,895

Rating: 4.8608694 out of 5

Keywords: educational, finance, investments, derivatives, options

Id: EMOMMxYDgok

Length: 17min 32sec (1052 seconds)

Published: Fri Jul 22 2011