$NET Earnings Play + How to Trade Earnings In General(Note that I am writing this idea about an hour after market open when $NET is trading around $90)
Thought I would publish a quick idea on how I like to select and play earnings on stocks. $NET looks like a decent candidate as an example and actual trade.
Earnings reports represent an opportunity for a BIG move, but we just don't know WHICH direction. Many newer options traders like to buy single-legged options (calls or puts) at very near expirations to express a hunch or opinion on direction. The options appear cheap with HUGE payouts if you hit a home run. But those are overwhelmingly losing trades, even when you get the direction right. Why? Implied Volatility (IV) gets absolutely JUICED for earnings plays.
For example, suppose I am bullish on $NET earnings and want to buy a call-
Buying the ATM $90 Call for 2/12 expiration means $NET needs to move up to $95 just to breakeven, and about $100 to give you about a 1:1 reward to your risk ($520 profit to your $520 debit paid)
Buying an OTM $100 Call for 2/12: breakeven is at $102, $104 is 1:1 R:R
If you think going out to the next further expiration is better, it's not. The 2/19 expiry on those same strikes produces similar price points to breakeven and 1:1 profit
ATM Call for next week's expiration
OTM Call for next week's expiration
To some that trade might not look that bad, but what is not shown on these charts (generated from theoretical calculators) is the impact of IV Crush . If we close today at $90, ER happens after today's close, and we open tomorrow around, say, $95, and close around $93, those calls are going to lose most of their value . The reason for this is people paid(really, over-paying) for a big move that did not seem to come. Most earnings have their biggest moves AT earnings, not a week after. The momentum is largely lost.
Impact of Implied Volatility, IV Curve, Implied vs Actual moves for previous earnings
Unless you have a crystal ball for direction, you generally want to buy or sell volatility based upon the expected magnitude of event
What this means is if currently the IV is sky-high up front and absolutely plummets in the months afterwards, you look to see what previous moves did vs what their implied moves did. I look at MarketChameleon.com for this.
If the actual move of the last 12 earnings as well as the average move is about equal to or less than the implied move was, generally people are over-estimating the magnitude of the move
The IV Curve/term structure gives you an excellent opportunity to buy or sell volatility on one term relative to another. If IV has been climbing and looks like its cooling off, you sell it. If IV looks like its been calm and is starting to climb up, you buy it. This is explained best buy buying a straddle at one term and selling a straddle at another.
More common term structure. Implied Volatility is relaxed but expected to rise -sometime- in the future.
Term structure you get with most earnings events or when Reddit wallstreetbets gets obsessed with a stock.
What are 'IV30', 'IV60', etc?
Options are instruments of TIME
Because they are instruments of time, we are always looking at the price of something relative to the future, and the future is generally different Options Expirations (OPEX) dates, usually the monthlies. For stocks they are very interested in OPEX dates occurring around special events like an earnings report, dividend, or some kind of conference, results of a trial, economic event, and etc.
Generally options markets are looking ahead at intervals of about 30 days. You see this with CBOE's $VIX index, which tries its best to reflect the outlook 30 days from now
(Per CBOE FAQ on VIX: "Only SPX options with more than 23 days and less than 37 days to the Friday SPX expiration are used to calculate the VIX Index. These SPX options are then weighted to yield a constant maturity 30-day measure of the expected volatility of the S&P 500 Index.")
Here's how I am playing Cloudflare $NET earnings-
Sell a straddle for next Friday (surprise surprise).
Tomorrow's expiration is absolutely jacked on IV juice, but it is a little TOO near for my liking. What if NET moves up to close at $110 tomorrow, but if I had just one more week it could've settled closer to $100 and made me a profit?
Tomorrow's expiration IV is 170, which is about 40% more than next Friday's 120, and will surely get crushed extremely hard if it doesn't produce a good move, but I get 30% more premium selling next week's expiration (2/19), and that one will also plunge if there's a non-move
We buy a straddle at a further out expiration, one where the IV is far lower
The idea here is that we are mostly playing Theta/time. The hope is that if the stock doesn't move much the value of the near-term straddle sold goes down significantly, while the far-term we bought goes down, but not as harshly. There's also potential for the IV curve to balance out so that the near-term lowers a bit while the far-term rises a bit, giving value to our long straddle while leeching the near-term straddle we sold
Here are some guidelines playing with Double Diagonals/Calendars-
Set a limit buy on the option you sold to buy it at $0.05, Good Till Closed. If you're short on an option and its basically lost all that value, take your risk off the board for a measly 20-something dollars. Who knows if you celebrate early and then a massive move happens, you could have just eliminated that risk potential (Remember to close your long one as well, or replace the short you closed with a new one)
I like to close the spread before expiry and not allow an ITM option to be exercised. That adds another dimension of complications most are not ready to deal with
Consider rollouts. If you sell the 2/12 or 2/19 and we get a nothingburger, most of the crush has probably happened by tomorrow's open. You buyback (Buy to Close) your $90 call and put and now sell (Sell to Open) a later expiration date, like the 2/26 or even the 3/19 (if you did a diagonal, this would make it an Iron Butterfly, if you did not you cannot sell the $90s since you are already long, you'll have to roll those out)
In the rollout scenario, it is sometimes pretty ideal to have your long straddle be at a much further out date because you can rollout your short straddle several times
I find that generally you are much more protected on big moves to the upside, less so to ones on the downside. This is related to a number of things like Implied Volatility, Skew, etc, but it's not a bad idea to place your straddle a bit lower rather than higher. Look at your Theoretical Options Calculator and see what is the most likely scenario
Good luck and happy trading. Please let me know if you have any questions, comments, etc. I am always learning and am susceptible to writing something incorrectly or even having a misunderstanding of things :)
