Earnings season for the second quarter of 2019 is more than halfway complete, and while the results so far haven’t been terrible, they haven’t exactly been rosy, either.
Through July 31, roughly 298 of the 500 companies represented in the S&P 500 had reported earnings. And of those reporting, the blended earnings-per-share (EPS) estimate showed an average aggregate decline of roughly 1.8%, according to FactSet data.
If this pattern holds up over the course of the remaining S&P 500 earnings yet to be released, this will be the second consecutive quarter in which aggregate EPS growth (year-over-year) for the S&P 500 will be negative.
Back-to-back quarters of aggregate EPS declines are usually defined as “earnings recessions.” This data provides further evidence that current concerns over the health of the U.S. economy may be warranted.
For traders, the main takeaway, however, is that there are still plenty of earnings releases yet to come in the month of August. And depending on one’s strategic approach and risk profile, these upcoming events may represent a great opportunity to add occurrences to the portfolio.
On the other hand, for traders that don’t embrace earnings, the end of the season may represent an opportunity to ramp back up. As outlined on a recent episode of Trade Logic Unlocked on the tastytrade financial network, there are a couple good reasons to be careful when managing an options-based trading strategy during earnings season.
This is especially true for traders that consistently deploy short premium positions in the options of single stocks. The complicating factor in these cases is that earnings generally represent a huge unknown, and on the day of the release the results can sometimes catalyze a big move in the underlying stock.
As a result, there’s a big difference between selling premium in a “normal” expiration (one that doesn’t include earnings) versus selling premium in an expiration month covering an earnings release.
The graphics below help highlight the difference between the risk profile of a earnings-based trade, versus one that doesn’t include an earnings event:
As one can see in the above image, especially the second one— the existence of an earnings event completely transforms the lifecycle of an option. Due to the uncertainty surrounding an earnings event, implied volatility actually tends to rise as the event draws closer. For premium sellers that were banking on a drop in implied volatility as expiration draws closer, this certainly isn’t ideal.
The good news is that previous research conducted by the tastytrade financial network shows there may be light at the end of the “earnings” tunnel. Through a comprehensive backtest of historical data, tastytrade research indicated that selling premium after earnings may be a prudent endeavor—depending on one’s risk profile and strategic approach.
The reasoning ties back to the fact that the conclusion of an earnings event means the company in question has released “all” pertinent information to the market. That’s because earnings announcements typically include not only financial data from the most recent quarter, but also forecasts for ongoing business prospects, and other updates on critical corporate developments/initiatives.
Following the above logic, that in turn means that in the immediate future (barring unforeseen events/occurrences) perceptions of the company’s value aren’t likely to change drastically.
Fortunately, this hypothesis can also be confirmed by the hard date—which is exactly what researchers at tastytrade proceeded to do.
Using 12 years of historical earnings data in five different single-stocks, tastytrade backtested how a simple short premium strategy (short straddle) performed when deployed immediately after earnings. The study and associated backtests encompassed 256 unique trades in the following symbols: AAPL, AMZN, GOOG, GS, and IBM.
In order to gain the best possible understanding of this trading approach, the tastytrade team also decided to run a concurrent study for broader context. In the second side-by-side study, the team investigated how the opposite approach compared – buying premium after earnings (i.e. long straddle).
The graphic below highlights the results of both studies – selling premium after earnings versus buying premium after earnings:
As one can see in the above graphic, the winning percentage (win rate) for the short straddle approach after earnings is attractive for all five symbols. We also see that 4 of the 5 symbols produced a positive average P/L. In contrast to those results, one can see that the long premium approach after earnings produced a win rate that was less than 50% in each of the 5 symbols backtested.
So while the earnings trade may not fit every trader’s risk profile due to the risk of big moves, the above data suggests there may be other avenues available to short premium traders that are patient enough to wait until the earnings event in a given symbol has passed.
Traders seeking to learn more about this trading approach can review the complete episode of Market Measures on the tastytrade financial network at their convenience.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to firstname.lastname@example.org.