Like Trading Options Over Earnings? Here is an Important Key to Your Success.

Earnings season is in full swing and it looks like volatility is starting to pick up. Trading stocks over earnings can be precarious since it is difficult to protect yourself if the stock you’re trading gets slammed. That is why many turn to option trading strategies as a means to control risk and still have some opportunity. However, without considering the implied volatility profile of the stock chosen, you may be trading the wrong strategy. Let’s talk about ways to improve your probability of success over an earnings play.
Since knowing the direction that a stock will move on an earnings is hard to predict (just look at FFIV today), a lot of people choose to trade straddles or strangles as means to capitalize on movement rather than direction. There are certainly times where straddles may make sense, but most people are focused on the price as opposed to the cost or implied volatility of the options they’re trading. If you’re not considering implied volatility pre-earnings you’re missing a huge clue as to the uncertainty over the earnings, how to select your expiration, and whether a straddle is necessarily the better bet.
One thing to look for ahead of the earnings is the average implied volatility for the several expiration months. If the February (front month) options have higher average implied volatility than the next available month (back month) it is a form of volatility skew. If this dynamic exists, one should immediately be weary of trading the February option and may elect to choose an expiration farther out. The reason for this is that the implied volatility on the front month in February will likely drop much more precipitously than the back months. When you’re a premium buyer, as in a straddle, this can take a move that would generally yield a profit and turn it into a loss.
Another point to make regarding earnings and volatility skews is when there is a substantive difference between the front and back month options. If that’s the case, then a straddle or strangle may not be the higher probability bet. These may be moments where a calendar spread is considered. A calendar is a trade where an option is sold in the front month and is purchased in the back month at the same strike. When there is a large skew you may find that by selling the front month option, two-thirds to three-quarters of the next month’s option you’re buying is covered. That makes for a cheap calendar.
So, the next time you’re speculating over an earnings look at the implied volatility in terms of not only level, but how the front month option may be skewed relative to the back months. This will help you not only know what option trading strategies may work best, but will also help you select an expiration when taking the role of a speculator as  with straddles and strangles. In the next article we’ll address what a calendar is.