Add This Earnings Season Trick to Your Trading Arsenal

We’re coming to the end of “Sweet Week,” when all the top companies are reporting earnings.

We’ve still got Apple (AAPL) and Amazon (AMZN) reporting today, and ExxonMobil (XOM) reporting tomorrow.

Now, we’ve talked recently about the “right” way to trade earnings. Broadly, it goes like this:

1. Find the stocks that consistently experience a spike in implied volatility (known as IV Rush) ahead of earnings

2. Place your trade a few weeks before the announcement

3. Exit your trade at the close of the session BEFORE the earnings announcement

After earnings, implied volatility crashes back down to earth. This is known as IV Crush – and if you’re holding the stock or an option, the price is likely to follow.

The biggest problem, as I’ve noted before, is that implied volatility is not a directional indicator.

Today, I’m going to show you how to solve that problem.

Let’s get to it.

How I Find the Best Earnings Trades

Most investors hear “volatility” and assume it means that prices are likely to go lower. That’s not always the case. (As I noted a couple of weeks ago, we saw some “socially acceptable” volatility – volatility that pushes prices higher – on July 5.)

A spike in implied volatility doesn’t tell you whether the stock is going to move up or down – just that it’s likely to move.

When I’m trading earnings, I look back a full year at the implied volatility around earnings. I’m looking for a directional move that happens 75-100% of the time over the last year.

Ideally, I want a stock that’s moved in one direction at least 3 of the last 4 earnings cycles.

But sometimes, those opportunities aren’t available, and the only trades are a 50-50 proposition.

Half the time, the stock moves up. The other half, it moves down.

So what do you do?

If your answer is “sit this one out,” I don’t blame you. I don’t like even odds – and a 50% chance is not enough for me to risk any capital.

But there’s an easy way for options traders to tip the scales in their favor and place a trade to profit whether the stock moves up OR down.

In fact, the only way you can lose on this trade is if the stock goes absolutely nowhere.

And with IV Rush, that isn’t likely.

Here’s what you need to know…

Straddling Stocks that Move Big into Earnings

Here’s a chart of Conagra Foods (CAG) on September 11, 2023:

Notice that the stock ran up hard two earnings announcements prior and then down one earnings announcement prior (green “E” triangles are earnings announcement dates).

Of course, we can’t on the stock moving up or down given the mixed directional movement the prior two earnings, so buying a call or put is a 50/50 proposition.

That’s where the straddle comes in.

We can literally play both sides of the trade by buying a call AND a put. If the stock goes up, the call option will make more money than the put options will lose. And the same is true in reverse – if the stock goes down, the put option will make more than the calls will lose.

All of this can easily be seen in a risk graph.

The above risk graph illustrates the profit and loss situation of straddling CAG.

Buying the October 6, 2023 $29 Call AND the October 6, 2023 $29 Put creates a straddle that will profit should CAG move anywhere.

Of course, there is risk if CAG doesn’t move as illustrated by the “witches hat” portion of the risk graph. As time erodes, value bleeds out of the option. The red, blue, green and black lines are 4 snapshots in time that illustrate time decay.

Working against time decay is IV Rush. We know IV will spike into earnings, so even if the stock doesn’t move, we can count on losing less than if we didn’t have the benefit of IV Rush keeping time decay in check.

Case Study: Conagra Foods (CAG)

Now, the CAG trade came from a scan I developed that tracks stocks that have consistently high IV Rush ahead of earnings.

Below is the scan result for CAG, revealing a massive IV rush of 288.78% over the past 2 earnings cycles…

It also indicates that straddling CAG 24 days before earnings produced an average 54.14% ROI.

Just like with my Money Calendar trades, it’s history. Plain and simple.

Will it repeat?

Most of the time it does, and with the built-in risk mitigation of earnings straddles coupled with IV Rush into earnings, winners normally outpace the losers in terms of the average gain/loss.

So let’s see how the CAG trade played out…

Here is the risk graph page on the entry date recommended entry date of 9/11/23:

We had $447 of risk on this trade with the plan to exit on October 4, the last session before earnings were reported the following morning before market open.

And here’s what happened…

The stock tanked into earnings (like it did the prior earnings period) netting a 56.4% profit on our straddle.

In summary, here’s a quick, three-step process for building a straddle to profit on a big earnings move:

1. Find stocks that consistently move big into earnings.

2. Place an ATM (strike close to stock price) 7-days into earnings.

3. Use the first expiration date available AFTER the earnings date.

Now, I know this can be a lot for novice traders – especially if you’re new to options.

So if you have any questions about straddles, drop them right here and I tackle the best ones in an upcoming Friday Mailbag.

Good trading,

Tom Gentile
America’s Pattern Trader