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Risks Of Trading Earnings Estimates – Don’t Go Down The Rabbit Hole

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Introduction

 

 

For short term traders, earnings announcements can be an opportunity for big price moves in either direction, up or down, but earnings announcements can be unpredictable events.

So unpredictable that even seasoned professionals think short term trading around earnings is highly speculative and risky.

In fact, many traders avoid trading around earnings all altogether.

In this lesson, we will explain the risks of trading earnings estimates – as you’ll learn why the impact of earnings announcements is unpredictable, how implied volatility changes before and after earnings, and how these implied volatility changes can affect option prices.

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Risks Of Trading Earnings Announcements

 

 

When earnings are announced, they’re immediately scrutinized by analysts and compared to previous estimates.

A stock price tends to react immediately and sometimes dramatically – as these reactions can occur even before the report is thoroughly examined.

Then, as more information is absorbed, the stock price may move in several directions before establishing a clear trend.

Therefore, even if traders can accurately predict the contents of an earnings report, it may not be able to predict a stock’s initial reaction.

This is why it’s risky to buy or short stock before earnings. Its nearly impossible to predict the direction and timing of those moves.

 

 

An alternative to directly buying or shorting stock is to consider using options.

An options premium is based in part on implied volatility, which is the market’s expectation of how much a stock could move over the life of an option.

Therefore, implied volatility can factor in large swings that can occur from an earnings announcement, and prices these swings into the options premium.

But this pricing in brings its own risks.

Implied volatility tends to rise in the weeks and days prior to an earnings announcement.

If the stock market expects the stock price to rise or fall dramatically, implied volatility can rise significantly.

 

 

Implied volatility is closely related to the buying and selling activity in the options market.

As options traders scramble to position themselves before an earnings announcement, the demand to use options for protection and speculation grows.

As buying and selling escalates, implied volatility also increases.

After an earnings report is released, the unknown factor driving uncertainty is removed, so implied volatility tends to drop quickly.

 

 

Whether the report is positive or negative, this drop in implied volatility causes an options premium to decline. Option traders sometimes refer to this phenomenon as a “volatility collapse”.

Lets look at a simplified example to learn why this can be problematic for traders.

Suppose an option trader anticipates an upcoming earnings announcement to be very positive and beat analyst estimates.

As a result, they expect the stock price to rise and buys an in the money call option for $10 the day before earnings with 10 days until the option expires.

 

 

This $10 premium is derived from a complicated formula, but for simplicity, lets say that $5 is based on the underlying stock price, $2 is for the time left for expiration, and $3 represents the high implied volatility.

The company announces earnings in line with its estimates and provides an encouraging outlook for the future quarter – and as a result, the stock price rises.

Each component of the call options price changes.

The portion relating to the stock price rises from $5 to $6, which is a 20% increase.

The portion representing time decreased a little each day the investor owned the contract.

However, it has not changed significantly and is still around $2, because there is still time remaining until expiration.

 

 

And as expected, implied volatility has collapsed from $3 to $1.

In total, the call is now worth $9.

As you can see in this example, even though the stock price increased, the decrease in implied volatility caused the option contract to lose money.

This can be a frustrating experience for an option trader.

 

 

So whether directly opening stock positions or using options, trading around earnings announcements can carry significant risks.

Understanding these risks can help you avoid costly mistakes and make informed trading decisions.

 

 

Quick Recap

In Review…

Cons Of Trading Stock Earnings

 

  • When earnings are announced, they’re immediately scrutinized by analysts and compared to previous estimates
  • A stock price tends to react immediately and sometimes dramatically – as these reactions can occur even before the report is thoroughly examined
  • Then, as more information is absorbed, the stock price may move in several directions before establishing a clear trend
  • Therefore, even if traders can accurately predict the contents of an earnings report, it may not be able to predict a stock’s initial reaction
  • This is why it’s risky to buy or short stock before earnings. Its nearly impossible to predict the direction and timing of those moves
  • So whether directly opening stock positions or using options, trading around earnings announcements can carry significant risks
  • Understanding these risks can help you avoid costly mistakes and make informed trading decisions

 

A Less Risky Alternative Could Be To Trade Options – But This Too Has Its Own Complications…..

 

  • An alternative to directly buying or shorting stock is to consider using options
  • An options premium is based in part on implied volatility, which is the market’s expectation of how much a stock could move over the life of an option
  • Therefore, implied volatility can factor in large swings that can occur from an earnings announcement, and prices these swings into the options premium
  • But this pricing in brings its own risks
  • Implied volatility tends to rise in the weeks and days prior to an earnings announcement
  • If the stock market expects the stock price to rise or fall dramatically, implied volatility can rise significantly
  • Implied volatility is closely related to the buying and selling activity in the options market
  • As options traders scramble to position themselves before an earnings announcement, the demand to use options for protection and speculation grows
  • As buying and selling escalates, implied volatility also increases
  • After an earnings report is released, the unknown factor driving uncertainty is removed, so implied volatility tends to drop quickly
  • Whether the report is positive or negative, this drop in implied volatility causes an options premium to decline. Option traders sometimes refer to this phenomenon as a “volatility collapse”

 

 

Earnings season can be an extremely busy and chaotic time for traders and investors as they attempt to gauge, monitor, and reposition themselves for the next fiscal quarter. You may see some traders or investors taking action by buying and selling stocks – or a slightly safer resort, trading binary options (It should be noted that trading equities or derivatives requires experience and expertise – as trading these assets can expose you to risk. If you are interested in learning more about binary options, browse our Module 4 Library).

However, with the excess implied volatility and speculation that is going around at this time – it may be wise for one to “hold their cards” so to speak, and let the hype die down shortly after the announcements.

Remember, you are building a self-sustaining investment portfolio and it is important to make calculated and rational decisions rather than to buy in to the hype and overreact to negative corporate earnings from a stock that you have been holding on to.

And always remember to think long-term with the end goal in mind as you choose to strategically invest capital in the stock market.

Make sure to due your due diligence first and make your judgment based on the facts and figures that you have already assessed.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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