It’s Not Too Early to Begin Thinking About Earnings Season

Welcome to October.  Autumn weather arrived in the Northeastern US just as the calendar turned.  Normal people might begin thinking about fall foliage, apple cider, pumpkins, and sweaters, but investors and options traders alike need to begin considering how this month’s earnings season might affect their strategies.

Some of you might be thinking, “Earnings season?  That doesn’t start for nearly two weeks.”  Hey, you’re not wrong.  JPMorgan Chase (JPM) and several of its other major bank peers announce results on October 14^th, kicking off the festivities.  Many other financials and a wide range of industrial companies announce during the following week.  Tesla (TSLA) leads the pack of mega-cap tech stocks when they report on the 19^th, and the wave crests in the last week of the month.

Although we have been in a bit of an earnings drought, some of the recent results have not been encouraging.  In recent days, FedEx (FDX), Nike (NKE), CarMax (KMX), and Micron (MU) all reported either disappointing earnings, reduced guidance, or both.  Four companies hardly make a robust sample, but they are a disproportionate piece of the available data and represent a fairly wide swath of the economy (transportation, consumer, tech).  Ready or not, we need to be thinking about how to position or hedge ourselves for what could be a rockier than normal set of results.

Even though earnings releases and the market’s subsequent reactions are difficult to predict, options traders utilize a predictable set of strategies to prepare themselves.  One of the most basic tactics is to boost implied volatilities for the dates that encompass earnings releases.  Compare these two implied volatility graphs for JPM and TSLA, noting the relative levels of implied volatilities for options expiring on the 14^th and 21^st of this month:

JPM: Implied Volatility by Expiry, October 14^th (green), October 21^st (yellow), November 18^th (orange)

Source: Interactive Brokers

TSLA: Implied Volatility by Expiry, October 14^th (blue), October 21^st (yellow), November 18^th (orange)

Source: Interactive Brokers

Note that JPM options expiring on the 14^th have the highest implied volatility while those expiring on the 21^st are highest for TSLA.  (We use the following month’s regular expiration as a control group for “normal” volatility).  

This should make perfect sense.  We know that companies have a propensity for greater movement after they release earnings, and we can track how much a given stock has moved after prior reports.  According to Bloomberg data, JPM’s average post-earnings move is 2.04% and TSLA’s is 7.35%.  Market makers use that sort of data in their models, which tend to be reflected as a boost to the one-day volatility for the earnings date. 

If we think of an expiration’s implied volatility as the market’s best estimate of the average daily moves that the stock will experience during that ensuing timeframe, the relative importance of a day with excess volatility will increase as that day approaches.  That is why we see the earnings week’s volatilities increasing faster than those of the non-earnings weeks.  Bear in mind also that JPM’s earnings also that JPM’s report on the 14^th will still affect the pricing for options expiring on the 21^st, though in a less dominant manner, while TSLA’s earnings should have no impact on options expiring 5 days prior (barring a pre-announcement).

There are 9 trading days after today until October 14^th, 14 until the 21^st, and 34 until November 18^th.  The effect of an extra day of volatility is much more muted by the following month, which is why the November volatilities seem relatively unaffected. 

Here is what to keep in mind:

• stocks tend to reflect higher implied volatilities for options that expire in the week of their earnings release than those in surrounding weeks (an “earnings boost”)
• stocks that have demonstrated a higher propensity for larger post-earnings moves will tend to see greater implied volatility boosts in their earnings periods
• the effect of an earnings boost grows in relative importance as we approach an earnings date
• the implied volatilities tend to drop dramatically after the earnings boost is removed from the calculation

These factors introduce a key element of timing for speculators and hedgers.  Even though implied volatilities tend to increase as earnings dates approach, the options may become less expensive in absolute dollar terms because options with higher implied volatilities tend to decay faster.  Many speculators prefer to wait until the final day, hoping to avoid as much decay as possible, but they may face wider spreads and worse liquidity if fewer are willing to take the other side just before an event.  Also, volatility assumptions may change dramatically based upon supply and demand and whether similar companies have beaten or missed their numbers.

Trading ahead of earnings can be as much art as science, especially in a quarter when results and outlooks may be in greater flux than normal.  Hopefully an understanding of the factors that move implied volatilities ahead of earnings releases can move the needle a bit more in one’s favor.