Jumping into trades for the new year of 2019 we’re into earnings season right away. $TataELXSI kicks off the earnings season with announcement of its Q3 results on 08-Jan. Previous earnings announcements for $TataELXSI have been around 1-2pm for the past couple years.
What are earnings trades?
Earnings announcements are key event points in time. Due to the market expectations of how the fundamentals of company are moving, a number of different expectations build up in the options marketplace. Bullish traders look to buying calls and bearish traders grab at those puts. This additional demand for options leads to an event based increase in options implied volatility.
The market expects a certain move across the earnings event as priced in the options. Observations of past earnings announcements has been that this level of elevated implied volatility is matched only a few times with the actual moves of the underlying. A majority of earnings announcements are met with actual moves (realized volatility) that are less than the expected moves (implied volatility). Once the announcement is out, there is no further excess demand for the options and this leads to a drop off in the implied volatility, also termed as the Volatility Crush. This volatility crush is what earnings traders look to exploit.
In this note we will focus on an earnings trade that is the short volatility. There is another subset of trades that are long volatility going into earnings. In this trade the traders look to buying options and ride on the increasing implied volatility effect as the earnings event approaches. We will leave that for another time.
What is the earnings trade setup?
An earnings trader looking to play the volatility crush will sell options pre-earnings and look to cover her position once the announcement is done.
Before we look at the structure of an earnings trade, let’s take a look at the Implied Volatility profile leading up to earnings. The price, implied volatility and historical volatility time series is shown below for $TataElxsi.
The rise in the implied volatility (purple line) in the lower pane is clearly visible leading into the earnings dates as marked on the upper pane with the dotted lines. This effect is pronounced in the last two earnings for $TATAELXSI. For other underlyings this effect is more pronounced. See the example of $INFY.
$INFY by far shows the most pronounced manifestation of this earnings implied volatility effect across all underlyings on the NSE.
So with this in mind, there are several ways and means to create short volatility structures. Various traders use different rules to enter, manage and exit these types of trades. The trades might be risk undefined as in short straddles at the money or short strangles that are out of the money. They might even be based off of some particular view of the underlying that the trader might have on direction coupled with the concept of volatility crush. The trades might also be risk defined on one or both ends with a option bought to cover risk on the particular side. Whichever flavour interests you, I will leave you to figure it out.
The key premise of the trade remains that the market seems to overestimate earnings moves. Just don’t be caught with your hands dirty when it doesn’t.