Heres how to trade options during the corporate results for quick profits!
Let us now understand how earnings can affect an underlying as well as that underlying's option market.
The IT bellwether - TCS officially set afire the ceremonial starters’ pistol for Q2 corporate earnings on October 10, 2022. Going forward, in the next 20-30 days, there will be a host of corporate earnings that would be offered on D-Street. The market participants, especially options traders, are quite active during the corporate earnings season. Hence, presenting to you an article on why it’s important to understand how earnings can affect an underlying as well as that underlying's option market.
Corporate earnings and implied volatility
I’m sure we are aware of what corporate earnings are - it’s an earnings report, which is usually announced by the company on a quarterly basis.
Now, what’s implied volatility? Implied volatility indicates the expected volatility of the underlying asset over the life span of the option and not the historical volatility of the underlying asset.
Usually, option price increases if implied volatility increases and vice-versa.
Let us now understand how earnings can affect an underlying as well as that underlying's option market.
Typically, as the earning announcement gets closer, implied volatility tends to shoot up in anticipation that a huge move might occur in the underlying due to earning announcement as market participants buy options to either speculate on the announcement or hedge their stock positions, which results in higher option prices and higher implied volatility.
After earnings are announced, the uncertainty of what will happen disappears and as a result, we see a sharp decrease in implied volatility. It’s common to see the implied volatility curve take off at speed of a plane as the announcement nears, and soon after the announcement is out, it starts to taper off or crush (although the expiration cycles closest to the announcement tend to rise & fall by greater percentage amounts).
Because of this, it would be prudent for the market participants to stick to premium selling strategies when it comes to corporate earnings play. A market participant can take gain from the implied volatility crush by selling the premium prior to the announcement, and buying it back after the announcement. This is specifically factual if there is not a very wild movement in the underlying.
It can be particularly confusing when it comes to the movement of underlying based on earnings. There are times when earnings exceed expectations but the stock price still falls. On the other hand, earnings may fall short of expectations but stock prices tend to rise. For this reason, it's better to play on the implied volatility side of earnings. Meanwhile, trading directionally on earnings can be extremely difficult, but the probability is higher of implied volatility expanding & contracting immediately after the earnings announcement. Hence, it's better to position yourself in such a manner that one may benefit from implied volatility contraction.
Earnings announcement trading is not for everyone as it involves a high degree of uncertainty and random movements. With that in mind, it may be an interesting way to keep involved when the market is not giving opportunities elsewhere.
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