Trading the Main Event

The American Heritage Dictionary of Business Terms defines "event risk" as "the risk that some unexpected event will cause a substantial decline in the market value of a security."

We would expand upon this definition on several fronts. Events such as takeovers and earnings reports can cause stock prices to make huge, fast moves—in either direction. In the traditional, old-line investment world, it might make sense to define the associated "risk" as a substantial decline in the share price. But in the modern trading world with its hedge funds and short-term traders, who may as easily be holding short positions as long positions, and with the added flexibility investors have to profit on bearish views by buying put options, event risk is now "an equal opportunity" phenomenon. A sharp reaction to the upside could be at least as devastating to a short seller or a put holder as a sharp decline would be to a stock or call option owner.

In addition, the dictionary definition of event risk refers to an "unexpected" event. We all know that events (mostly bad ones) can occur out of the blue—terrorist attacks, wars, natural catastrophes, and corporate takeovers would be prime examples—but there are also market-moving events that are scheduled well in advance. The most common are quarterly corporate earnings announcements, but there are others that can have a huge market impact. Our good friend Paul Montgomery, whose weekly Universal Economics market analysis we find to be the most compelling in our business, refers to these events as having "dates certain." As Paul described to us recently:

"What I call 'date certain' is a future date, known to virtually all market participants, that is commonly believed to have significance for the markets. Probably the classic example was January 16, 1991, which was the deadline date George Bush Sr. had given Saddam Hussein to abandon Kuwait. The whole world knew about, and watched, that date for six months. Then exactly on that date the troops started to move, and the stock market exploded into one of the strongest bull runs ever."

You Know More Than You Think

One fascinating aspect of "date certain" events is that even though they can have an explosive impact on a stock or on the market, you as a trader can plan your strategy in advance and execute it just before the event is scheduled to occur. This means that you can position yourself to achieve big profits in a very short time period—often in less than a full trading day. And such situations can be particularly attractive for option buyers (due to the added leverage and the reduced dollars at risk) versus an outright purchase or short sale of the stock.

Another aspect of trading such events is the critical importance of the psychological component—the expectations ahead of the event. This is often a much more significant driver of post-event price movement than is the information contained within the actual event. If earnings expectations are unrealistically high and this opinion is shared by too many investors, there is almost nothing a company can report that can drive the stock higher. The "expectations bar" is just set too high. Similarly, excessively negative expectations can set a very low bar, and the stock might rally even on a "weak" report. As Paul Montgomery puts it: "The point is not that the event itself is inherently bullish or bearish. In fact, the date certain event may inherently have no fundamental investment significance at all. But because the anticipation of that date prompted behavioral change, these date certain events often show up as inflection points on the charts."

As practitioners of Expectational Analysis® for more than two decades, we at Schaeffer's are uniquely positioned to assess this "sentiment backdrop" ahead of events such as earnings, and to develop option strategies to profit from the post-earnings market reaction.

Sentiment is Everything

Perhaps the most important element of an option's price involves the volatility expectation, otherwise known as implied volatility, which directly affects an option's extrinsic value (time premium) based on how much the stock is expected to move prior to expiration. For our purposes, we want to know how much the stock is expected to move immediately following an event. Ahead of known events such as earnings reports, where the outcome is uncertain, implied volatility in the options is typically higher, and thus their premiums are significantly more expensive because the movement in the stock is expected to be greater than usual following the event.

The extra volatility premium going into an event introduces an additional hurdle that the option buyer must overcome: Not only must the stock move in the desired direction, but the magnitude of the move must also be large enough to overcome the volatility "crush" after the event, when volatility recedes and the option's time premium collapses. For this reason, when developing an option buying strategy to trade events, it's crucial to mitigate volatility risk as much as possible.

Pre-Event Trading: Putting Time on Your Side

The easiest way for option buyers to mitigate volatility going into a date certain event is to only trade events that occur during expiration week and simply buy front-month options the day before the known event date occurs—when time premium is nominal, and the stock has a high probability of an explosive move after the event. This may run counterintuitive to other option buying strategies, in which time decay is a concern. However, for event trading, you are only going to be in the trade for a very short period of time (as little as one day). Time decay is not much of an issue. For the event trader, expiration week is the optimal time to make your move: Your leverage is at its greatest, you have the fewest dollars at risk, and the "penalty" of higher volatility premium is minimal.

Using a hypothetical bullish example on stock XYZ at $25, let's take a look at the profit/loss picture on the same call option going into an earnings event. We'll demonstrate how it would react to identical drops in volatility, different time frames, and either no change in stock price or a $1 change after the event (see Table 1).

Note that in the first scenario, with 14 days to expiration, the longer-term call is $0.90. In the second scenario, with 3 days to expiration, the shorter-term call is only $0.41, which is also your maximum risk should the stock move completely against you—already a better deal! The following two examples lay out the profit/loss scenarios depending on if the stock moves or doesn't after the event.

STOCK DOESN'T CHANGE. Fast-forward to the following morning and the subsequent announcement before the bell—earnings are in line with estimates. The stock reaction is nil and opens up unchanged at $25. Now that the uncertainty of earnings has been removed, the calls suffer a volatility "crush" as implied volatility recedes from 45% to 30%. In the first scenario, the longer-term call opens up at $0.58 for a -$0.32 loss, while the short-term call opens at $0.23 for only a -$0.18 loss. While the stock hasn't changed, you can see that the options certainly have! While they both suffer losses, contract for contract, the short-term options have left you with more capital in your account.

STOCK MOVES $1. Now, imagine the earnings announcement is better than expected, and the stock actually jumps up $1 at the open. While suffering the same volatility crush as in the prior example, all other things being equal, the longer-term call is now $1.23 (profit of $0.33), while the short-term call jumps to $1.01 (profit of $0.66!). Again, options during expiration week have greater leverage ($0.60 profit versus $0.33) with fewer dollars at risk ($0.41 versus $0.91), and don't suffer as much of a loss should volatility get crushed (-$0.18 versus -$0.32). Are we getting through yet?

Of course, ideally, in order to increase our odds of achieving that big post-earnings stock move in our favor, it's good to look to buy call options when pre-earnings investor expectations appear to be very modest. In such situations, the "expectations bar" is often so low that even a mildly favorable earnings report can catapult the shares sharply higher and take those options along with it.

Now, if you're bullish on a company's fundamentals, but less certain about how the market will react to its earnings announcement, you can create various call and put combinations, such as a bullish strangle that could profit from a large move in either direction. The way you set this type of trade up is to purchase a call option in the money (ITM) and a put option of the same expiration, with a higher strike, either at the money or out of the money. In the case of our XYZ example, assuming 3 days to expiration and implied volatility at 45%, you would buy the 22.50 call for $2.51 and the 25 put for $0.41, for a total of $2.91. Because the call option is so deep in the money, it's almost entirely "real value," and thus trades near parity (dollar for dollar) to the stock. The cheap put simply acts as your hedge in case the stock reacts poorly to the earnings. By setting up the strangle this way, your total risk in the trade is just $0.42—the cost of the put plus the penny in time value on the call. This is essentially the same risk as that of the straight ATM call purchase in the prior example, but now you have profit potential on the downside as well.

Post-Event Trading—Capitalizing on Certainty

In trading "post-events," because the element of uncertainty is removed, you can make decisions based on more factual information, while the options are much cheaper. If the news is sufficient to change the market's perception of the shares, this could create a sustainable move in the direction of the immediate price reaction, and buying options at much cheaper prices when the volatility premiums are minimal might make sense.

A "trade trigger" in post-event situations can occur when the event outcome is counter to the crowd's pre-event expectations. And as with pre-event trading, an option buyer can achieve a tremendous amount of leverage when focusing on trading post-events during expiration week. But also in post-event situations, you can consider buying longer-term options to take advantage of those situations where the immediate post-earnings reaction is the prelude to a much larger and more sustained move. One strategy might be to buy a three-month option with the intention of closing your position before the next quarterly earnings announcement, so you have a pure post-earnings play during your holding period without any event-related "speed bumps."

Final Thoughts

While we can neither predict nor trade in front of "out of the blue" events like financial catastrophes and terrorist attacks, "date certain" events such as earnings announcements offer a unique opportunity for the option trader to capture potentially explosive stock movements in very short time frames. We don't know what specifically will be announced and/or reported, plus the market's post-event reaction. However, by buying options just ahead of these events during expiration week, you can control your risk and obtain a better reward/ risk ratio if the stock has an extreme reaction. And by properly measuring investor expectations ahead of the event, you can help tilt the odds in your favor of getting the post-event direction right.

Key events like earnings announcements, management shake-ups, and upgrades/downgrades can create big stock moves. Trade options on these events and target huge gains. Click here to learn more.