Ultimate Earnings

Trade Guide

Published by Option Alpha. All Rights Reserved.

About the
Author
Kirk Du Plessis is a full-time
options trader, real estate investor
and entrepreneur.

Before launching Option Alpha more than 8 years ago, he

was an Investment Banker for Deutsche Bank in NY with
the Mergers & Acquisitions group, a Capital Markets
Analyst for BB&T in DC covering REITs and a Senior Loan
Officer in the mortgage industry.

His training courses and coaching programs have helped

thousands of traders from around the world learn how to
make smarter options trades. He was recently featured in
Barron’s Magazine as a contributor to the Annual Broker’s
Review and is the head trader here at Option Alpha.

Though a long-time resident of Virginia, he currently lives

in Pennsylvania with his beautiful wife and daughter.

Published by Option Alpha. All Rights Reserved.

What’s An “Earnings” Trade?
Every quarter we go through “earnings season”, a time
when public companies announce their performance and
give guidance for the coming months. This is a highly
anticipated (yet nervous) time for investors because they
either get confirmation of a company’s strong growth or
news of a slow down in revenues and profits.

As options traders, we frankly don’t care what happens

with a company when they announce earnings. The stock
could jump higher or drop like a rock. What we are after is
the drop in implied volatility that follows.

In the weeks before a company announces it’s quarterly

results the options market for that stock sees an increase
in overall trading activity and volatility. This is mainly the
result of heightened fear of the “unknown”.

Will the company post strong sales growth? Are they

laying people off and closing stores? Did their new life-
saving drug get FDA approval?

There are literally thousands of unanswered questions

which causes option volatility and prices to swell (on both
sides) in anticipation of the event. Now, you might assume
that we could just buy options in advance of earnings and
profit from the rising prices right? Nope. Even during a
seemingly consistent increase in volatility we find that IV
will still over-state the expected move. Plus, we have no
way of knowing when the IV level will top out before
earnings. Some stocks see IV at it’s highest 3 days before
earnings and others 10 days before earnings. The data
just isn’t consistent enough to make a trade on.

The higher probability trade then, is to profit from what is

commonly called the “IV Crush” or the rapid drop in option
pricing volatility the day after earnings are announced.

It’s this 1-time IV slide that we are targeting because it’s

been proven to happen time and time again. As soon as
the company announces it’s earnings (good or bad)
volatility in the options drop because now investors have
the information they were looking for.

The “unknown” is behind them now and even if the news

is really bad at least they know what’s going on. This level
of certainty in future stock direction (again even if it’s
lower) causes a dramatic drop in option prices on both
sides which we can exploit and profit from.

In this guide we’ll break-down our strategy from start to

finish for placing profitable earnings trades each quarter.
The ability to leverage these trading opportunities with
targeted strategies has been very profitable for us over the
last couple years and we look forward to sharing the
roadmap with you in the pages to follow.

Some text


Part 1: Screening
Stocks to Trade

Helping you set some basic guidelines to figure out if a

stock is good enough to trade earnings on or not.
Finding Great Stocks.
A profitable earnings position starts with your ability to find
great stocks to trade. Thankfully this isn’t hard at all. In
fact, it’s rather easy once you know what to look for.

Visual Backtesting
The first thing you should do once you identify a stock that
has earnings coming up is visually backtest the drop in IV.
Does the stock actually see a drop in IV after earnings? Is
it a small drop or big crush all the way down?
Since we are focused solely on profiting from the IV drop,
the bigger and faster the drop the better the trading setup.
In the example above, notice that the stock does have a
significant drop in IV each time earnings are announced.

The stock below however has a much less dramatic drop.

Not to say that you can’t trade the one below but your
“edge” isn’t as great as if you were to focus on stocks that
show a bigger magnitude drop.

Plus, you’ll notice that the 2nd stock is much less

consistent in showing the IV drop. So, it’s in your best
interest to use a visual backtest to pre-screen stocks first
before going any further in analyzing a trade.

Liquidity Requirements
After you have determined that you could consistently get
an IV drop it’s time to determine if the underlying stock and
options have liquid markets to trade.

Checking liquidity is a step that cannot be skipped. For the

underlying stock we like to see at least 1 Million shares
traded on average each day. This ensures that the stock is
incredibly liquid and the probability numbers we use are
derived from an underlying efficient market.

For the options themselves, we ideally like to see the at-

the-money (ATM) options trading about 2-3k contracts per
day with a minimum of 1k contracts and Bid/Ask spread
around 0.10 or less. Regardless of how good a trade
setup looks, if there are not liquid markets to easily get in
or out it’s not worth trading - period.

Some text.


Part 2: The Best

Timeline To Trade

Helping you focus on the best timeline and option

contracts to trade to optimize the potential IV crush.
The Best Timeline.
Earnings trades are 1 day events. They don’t last over the
course of weeks or months (thank God). The company
announces earnings and its over - done. Because these
“binary” or “targeted” events happen so fast we need to
adjust the timeline of our trades to compensate.

Trade Weekly Options

The best contracts to use for earnings trades are the front
most weekly options. These contracts will generally have
the most volume and carry the biggest volatility premium
increases before the event.

If they are not available

then you can trade the
closest monthly contracts
but I would only do so if the
days until expiration are
less than 20 days. Note
that during the 3rd week of
each month there are no
weekly options so you
would use the next expiring
monthly contract instead.

Enter The “Session” Before
Just as we would like to target weekly options to maximize
the drop in IV we also should look to enter our trade the
session before a company announces earnings to remain
as neutral as possible to any post-earnings move.

This means that if a company is due to announce earnings

“Before the Open” on Thursday, then we need to enter our
strategy as close to the close on Wednesday as possible.

Likewise, if a
company will
announce “After the
Close” on Thursday
then we want to
enter our strategy
the same day near
the close of the
market.

Some traders try to

enter their position
1-3 days in advance
but you run the risk that the stock makes a big move
ahead of the event. Doing this challenges your position
even before the IV drop that we are targeting and makes
you much more of a directional trader (see chart above).

Some text


Part 3: Strategy
Over Direction

Helping you select the best non-directional strategies to

use for earnings implied volatility drops.
Sell Expensive Options.
With a targeted focus on the IV drop we also need to be
100% clear on which strategies to use (and not) use when
making an earnings trade.

It should come as no surprise that the best way to profit is

to sell expensive options that have been over inflated and
buy them back later when they become cheaper after the
company announcement.

Short Strangles/Straddles

Our default and 2 favorite option strategies for earnings

trades are to sell short strangles or straddles. Both are
undefined risk trades that are “pure plays” on volatility
because we are don’t buy any options for protection.
These can be more capital intensive since they require
margin to hold the positions but also have a much higher
total dollar return because we don’t use our credit buying
options as part of a spread.

Short Iron Condors

If you are unable to trade undefined risk trades (or prefer
to have defined risk) then we suggest using iron condors.

These strategies are still net short option premium and

have lower capital requirements but also offer much less
overall profit potential.

Whichever strategy you

choose the steps that follow
will be the same since it’s
still based on selling OTM
options.

And whatever you do please

don’t try to buy options
ahead of earnings
attempting to pick the
direction and hit a home run.

It’s not a long-term strategy or business and I guarantee

you’ll consistently lose money. Stick to short premium.

some text


Part 4: Expected
Move Calculation

Helping you figure out how far the stock might move after
it’s announcement based on current options activity.
68% Expected Move.
One of the key data points we use when placing earnings
trades is found by calculating the stock’s 1-day expected
move. In statistics this is equivalent to a 68% confidence
or probability range. With this figure we can pin-point our
overall probability of success on each trade to more than
70%; dramatically increasing our win rate long-term.

Calculate Using ATM Straddle

The most accurate way to calculate the expected move is
to use the current value of the ATM straddle on the front-
most contracts (weeklies if available).

From there we multiple the value of the ATM by the

desired expected range we are looking for. In our example
below we’ll continue to use the 68% confidence or
probability range. And finally we’ll take this new figure and
use it in the next section (Part 5) to help determine the
best strike prices to sell for our strategy.

To better drive home this point let’s look at an example

with JPM’s stock currently trading at $59.34. As a reminder
we always use the “MARK” for determining an option’s
current price as this is the theoretical middle price.

Using the option table above we can determine that the
closest ATM straddle could be at $59. The MARK of the
calls on the left are $1.145 and the MARK of the puts on
the right are $0.775 for a total value of $1.92.

Now, if we are looking to capture a 68% expected range

we would multiply ($1.92 X .68) = $1.30 possible move UP
or DOWN following earnings.

This means that with nearly 70% confidence JPM will stay
inside a $1.30 move up or down following it’s earnings
release. I’ll give you a minute to really think about how
powerful this can be when trading options (start now).

Brining this level of definition to a seemingly “unknown”

event is how you consistently beat the market by placing
smarter trades.

Visualizing Expect Move
What we like to do as a final step (though not required) is
to visually look back at the chart of the stock and place
lines at the possible expected boundaries.

Using JPM’s stock chart we placed a line approve $1.30

higher and lower than it’s current closing price.

This helps define the trade for us and also shows us the
possible “profit window” for our chosen strategy.

some text


Part 5: Strike
Prices & Premiums

Helping you select the best strike prices for both the
highest premium and the best chance of success.
Setting It All Up.
Now that we have the expected move figure from Part 4
above we can use this number to help us select strike
prices that will give us the high probably of success we are
looking to hit. At this point, determining if we are collecting
enough premium also becomes a priority.

Camp “Outside” The Range

In order for us to be highly profitable we need to ensure
that when the company announces earnings, and stock
subsequently moves, we have sold options that are
outside of the expected range of $1.30 (JPM example).

Therefore, we should look to sell puts options more than

$1.30 below the market and calls options more than $1.30
above the market.

If we can go even further out on each end, great! The

more conservative you want to be within reason go ahead
and make this fit your risk tolerance and trading style.

From our JPM example, a $1.30 move below it’s current

price would be a put option around the $58 strike. And with
a $1.30 above it’s current price we would want to sell a call
above $61.64 or close to it.

Looking at the puts that JPM has available in the front-
most contract we would ideally sell the $58 strikes.

And with the calls that are available we would look to sell
the $61 strikes a little further out.

Notice that both short strikes are just outside the expected
range of the stock heading into earnings.

Collecting Enough Money
Only after you find that there are strikes trading outside
the expected range can you now look at ensuring that you
are collecting enough premium to make the trade worth
your time and energy.

This will be subjective for each trader but as a general rule

of thumb, we like to collect about a 5% return on strangles/
straddles and roughly 10% with iron condors.

These are not requirements but rather guidelines to help

you make a decision. The key is that there is “some value”
there to be realized. Don’t put hundreds of dollars at risk
just to at most make $10 or $20.

In our JPM example above selling a short strangle we

could take in $80 of premium or credit and the margin
required is $1,054 (7.59% max possible return).
With an iron condor because we would have to buy
protection on either end at the next strike prices out (57.5
puts and 61.5 calls) our total credit goes down to just $22.

But our total return goes up to more than 66% since the
margin required to hold the position is only $33.

You can now put context and hard numbers around our
previous comments in Part 3 about strategy selection. The
strangles offer 3X the total dollar profit but lower % return
because of capital usage when compared to iron condors.

Full disclosure, we would not trade the JPM iron condor

above because the credit is too low. Instead we would go
with the strangle or look for another (higher valued)
earnings trade.
Risk Per Trade By Account Size
1% 2% 3% 4% 5%

$5,000 $50 $100 $150 $200 $250

$10,000 $100 $200 $300 $400 $500

$15,000 $150 $300 $450 $600 $750

$20,000 $200 $400 $600 $800 $1,000

$25,000 $250 $500 $750 $1,000 $1,250

$50,000 $500 $1,000 $1,500 $2,000 $2,500

$100,000 $1,000 $2,000 $3,000 $4,000 $5,000

$250,000 $2,500 $5,000 $7,500 $10,000 $12,500

***Risk per trade is based of the maximum loss on the trade or initial margin requirement to hold the
position. For example, if you sell a $1 wide credit spread and take in a $30 credit your max risk is $70. If
you sold a $2 wide credit spread taking in the same $30 your max risk would increase to $170. For
undefined risk trades we will take the initial margin requirement. For example, if you sell a naked put
below the market and take in $90 of credit but the margin requirement is $1,200 then we base the max
account size off the $1,200 margin requirement needed to hold the position.

some textsome text


Part 6: Exiting
The Position

Helping you determine the best time to exit post-earnings

announcement to protect your profits.
Don’t Think, Exit.
Thus far we’ve been very mechanical and smart about
placing the right trade for the right earnings setup. Let’s
also be smart about how we maximize our trade exit. After
all, the entire goal of these 1-day trades is to profit from
the drop in IV that happens after earnings are announced.

Close On The Market Open

In order for us to be highly profitable we need to ensure
that we quickly exit all earnings trades that are profitable
soon after the market opens.

Should the stock move inside the expected range we are

very likely to see a profit materialize with IV dropping and
have to take action in closing the trade.

Back in January we traded BBBY around earnings and

notice our entry and exit timeline of real trades that filled.
We entered the trade for a $77 credit and closed it back
for a $50 debit take a small $22 profit in less than 1 day.

The Risk of “Letting It Run”
As the chart below shows of BBBY, the stock we analyzed
closed the day before earnings at $79.5 and had an
expected move of $4.50. The next morning the stock
opened right at the edge of the expected move and
because we exited quickly we were able to bank a profit
(though small, it was still a profit).

Then throughout the day the stock continued to move

lower heading down below $72.50. Had you waited to exit
and “let the small winner run” you would have surely taken
a much bigger loss by days end.

 Part 7: How To
Adjust/Hedge
some text


Helping you make smarter adjustments to stocks that

move outside the expected range against your strikes.
When Trades Go Bad.
Before we even start to get into the logistics of adjusting or
hedging earnings trades that go wrong it’s important to
remember that this is NOT a requirement.

As long as you place a lot of trades over the course of a

year with a high probability of success, you will be
profitable entering trades the session before and closing
them out on the market open (win or lose it won’t matter).

Implied volatility will always over-state the expected move

of a stock around earnings and those traders who sell
options will be the ones left with all the money.

That said, making the right adjustments can improve your

overall returns by turning possible losers into winners.

Adjusting for Risk First

We’ve already discussed that if you have a profit at the
market open you need to take it (big or small).

But if you don’t see a profit right away as a result of the

stock making a huge “unexpected move” what steps can
you take right away to reduce risk and still leave an
opportunity to profit?

The first adjustment you should make is to extend your
trading timeline by rolling the “tested” or “challenged” side
of the trade to the next monthly contract.

If for example, if we had the $26 strike calls on an

earnings trade and the stock opened much higher towards
our short strike we would roll them from Jan to Feb.

Rolling creates both more duration and time to be right

should the stock come back down as well as additional
premium which is used to widen your break-even points.

Notice that we don’t roll further up to say the $27 or $28

strike as this creates exponential loss compounding.
The next adjustment is to roll the “untested” or “un-
challenged” side that the market moved away from UP to a
closer strike price near the stock and OUT to the next
monthly contract.

Using the same example from above, if the stock moved

up towards our $26 short strike we would take our put
below the market (previously at $23) and move it up to the
$25 strike as well as moving it from Jan to Feb.

This again gives us more time to be right should the stock

come back down and even more premium which is used
to widen your break-even points further.
Roll And Wait for Profits
After rolling and adjusting your strike prices, it become a
waiting game. From here you should wait to see a profit or
close the trade near expiration of the back month contract
you rolled to (in this case Feb).

Let the probabilities work themselves out over time and

don’t be afraid to hold through a losing trade until it comes
back around.

Should the stock never come back then close the trade at
expiration in Feb with a loss and move onto the next one.

If you kept your initial position small and didn’t add to the
trade when rolling you’ll never (ever) experience a big
enough losing trade that knocks you out of the game.

Remember this business is about numbers and math so

don’t get emotional with trades that go wrong because
they will happen and you will need to be smarter about
how you “manage” them.
 We help you make “smarter”
more profitable trades…

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