April was the fourth month in which I focused my options trading on earnings announcements. With 49 trades on the ledger, I now have enough data to evaluate the strategy.
The methodology is a model of simplicity:
- Pick a direction for after an earnings announcement.
- Place the trade in the last session before the announcement.
- Exit immediately at 25% of maximum potential profit or greater.
Apart from those simple rules, I handled the trades the way I do all options positions: Hold on to the unprofitable ones in the hope that they’ll become profitable, and manage the positions 21 days (3 weeks) before the options expire, exiting positions that are profitable but below the target, and make a decision on unprofitable positions: Sell them or hold on hoping for a reversal in those three weeks.
And it has worked. For those 49 trades, the average return, before fees, has been 50.9%, not bad at all. That works out to a daily average return of 27.6%. It’s lower because I tended to hold the losing trades longer, under my general rules for managing positions. And indeed, when I converted the daily return to an annualized return, the difference showed, as a loss of 69.1% per day.
That loss figure is a quite fascinating. Out of 49 total trades, 40 were profitable. Nine trades pushed the results down to a considerable degree.
So what’s going on here? During the last four months my instincts told me that holding on to a losing trade generally increased the loss and led to complications, such as early assignment. And I think these numbers back that up.
Which leads to another question: What makes earnings plays different from general options trades? My theory goes like this: Most market movements are unfocused. Millions of traders all have their own different reasons for trading long or short, for choosing the trade price. As a mass they create patterns in their trades, as shown by the S&P 500 Elliott wave analysis I post each day. But their various motivations offset each other to a degree, making it more likely that today’s rise will be reversed tomorrow.
Earnings plays, however, are focused. When the price rises after earnings, the traders are motivated by the company’s announcement. Each of them has the same reason for trading as they do. That makes for bigger price movements, and greater certainty in those price movements. And so a price rise or decline will tend to be stickier than is the case with general trading. I think that makes it less likely that a losing trade will turn profitable.
That’s my idea, at least. The next question is, what to do with it?
Over the past four months, trades lasting one day have been the big winners, with a 61.9% return. The return declines to 11.0% for two-day trades, bumps up to 24.5% for three-day trades, and sinks to a sad dismal 6.9% for five-day trades. (I had no four-day trades in the sample.)
The return for positions held more than 10 days was 1.5% on average, and more than 20 days, a loss of 0.1%. The four trades kept more than 30 days produced a loss of 0.5%.
And of course those losing trades kept money tied up that could have been used for other trades.
So, yes, the methodology I’ve used up to now has worked. But I think it can be made better. My goal will be to get out of my earnings plays quickly, win or lose. Here’s how I plan to do it.
For any position:
- First day after entry: Exit at 25% of maximum potential profit or higher.
- Second day: Exit at any profit, no matter how small.
- Third day: Exit, loss or profit.
That ensures quick turnover and therefore a more efficient use of my trading funds. And so, I think it will improve the overall profit.
My plan is to use this method through July, and then assess the results.
I’ve updated my Earnings Plays rules in the Trading Rules dropdown on the menu. Here’s the new version:
Earnings Plays Trading Rules
- Enter a position on the final trading day before the earnings announcement.
- Select highly liquid stocks with options having an implied volatility rank of 30% or higher.
- Select liquid monthly options.
- Pick a direction for the expected move. There are many ways to do this. I use stock analyst opinion as tracked by Zacks Investment Research out of Chicago.
- My method: I choose stocks with a Zacks Rank, a longer term measure, that’s 1 or 2 for a bullish trade, or 4 or 5 for bearish. A 3 rank means hold and so is neutral and I avoid it. I also use the Zacks Expected Surprise Prediction (ESP), which relies on analysts changing their evaluation shortly before earnings. It is stated as a percentage, positive for bullish and negative for bearish. Zacks says that the tool is 70% accurate positive surprises, less for negative surprises.
- Other methods: Since traders bid the price of a stock up or down prior to earnings, a momentum indicator such as the RSI or MACD or Bollinger Bands can also be used as directional indicators, as can fundamental analysis or looking directly at analyst assessments
- Directional strategies: For lower risk (and lower returns), use short bull put spreads if a rise is expected, short bear call spreads if a fall is expected. For higher risk (and higher returns), short puts if a rise is expected, short calls if a fall is expected.
- If the stock has no clear directional bias, avoid the trade.
- The short strikes for each strategy ideally will placed be far enough out of the money to enclose the expected move. However, I will sometimes move closer in to improve the risk/reward ratio.
The expected move is calculated by taking the value of three positions and weighting them according to their distance from the at-the-money (ATM) mark.
- Using the options closest to expiration…
- take the price of an ATM short straddle and multiply it by 60% (0.6)…
- take the price of strangle one strike price away from ATM, and multiply it by 30% (0.3)…
- and take the price of a strange two strikes away from ATM, and multiply it by 10% (0.1).
- The expected move is the average of the weighted prices — add them together and divide by 3.
- Note that the expected move doesn’t anticipate the direction of the move — could be up, could be down.
By Tim Bovee, Portland, Oregon, May 1, 202
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.
All content on Tim Bovee, Private Trader by Timothy K. Bovee is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
Based on a work at www.timbovee.com.