The full title of this book is Trading on Corporate Earnings News – Profiting from Targeted, Short-Term Options Positions by John Shon and Ping Zhou.
I picked up this book some time during this latest earnings season because I got caught in some of the sell offs in my stocks when earnings were announced. I was long AAPL and got caught in the sell-off after its earnings was announced. I remember waking up (prior to the announcement) thinking that I should not have a long position, and should instead have played it with a straddle, but it was too late. Some of my other holdings (LF, RGR, ALLT) reported okay earnings, but got hammered as well. Even one stock that I held, TFM, that has yet to report earnings, got hammered when related stocks (e.g. SVU) reported poor results. These multiple expensive lessons really highlight the importance of managing your positions properly for earnings season.
Those experiences led to my current rule to always track the next earnings announcement date for my stocks, and only hold on to the position through earnings if I have a buffer of gains in that position. I will also not initiate a position in a stock close to its earnings release date, since there will likely not be enough time to build up a buffer.
Back to the book. The book quotes multiple results from academic studies on the topic, as both authors had backgrounds as professors of accounting. The book showed compelling evidence that it is very difficult to predict the market’s reaction to earnings announcement, hence a better way to play earnings is to do so with straddles or strangles.
The book goes into the details of which contracts to choose, entering and exiting the trades, etc. which I think is great, as this makes the book beginner-friendly. The explanations were written in a clear, easy-to-understand manner, and the book being around 200 pages, is a nice succinct read.
One of the interesting bits for me is the point on earnings surprise persistence. I have used that in my own trading in buying gap-ups, but I did that because it works, and did not have an academic grounding behind it. So earnings surprise persistence lends a very good support for a momentum trading style.
Overall, I think this book is a good read for someone to understand how stocks and options behave during earnings season, which is a necessary background for trading. You either learn it by paying tuition fees to the market, or by reading a book like this one.
Some of the key points are below:
Start and End of the Earnings Season
- Alcoa’s (NYSE: AA) earnings announcement date usually marks the start of the earnings season, the end of the earnings season is taken as roughly one month later.
Investors have Limited Attention in Processing Earnings Announcements
- When multiple announcements are clustered in a given day, investors tend to under-react to the news because they don’t have the time or ability to fully analyze the news.
- Investors tend to under-react more to earnings announcements made on Fridays.
Divergence of Forecasts Tends to Result in Lower Returns
- Diether, Malloy, and Scherbina (2002) used the standard deviation of analysts’ forecast to measure divergence of opinion. They found that stocks with high forecast dispersion tend to earn lower returns.
- Miller (1997) in his paper “Risk, uncertainty, and divergence of opinion” highlighted that stocks with more uncertainty tend to be overvalued if there are constraints on short sales. [My note: How high the stock price reaches depends on the people who are most willing to pay. E.g. if there are 100 shares, and there are 150 people that wants to buy, the price is set by the top 100 buyers. If there is more uncertainty, the spread in buyers’ willingness to pay will be wider, hence the price set by the top 100 buyers will be higher.]
Market Movements Foretell Earnings
- Ball and Brown (1968), in a study published over 40 years, found that stock prices tended to steadily run up several months before good earnings numbers were actually reported, and prices tended to steadily trail downward several months before bad earnings were announced.
Options Order Flows Tend to Lead Stock Order Flows
- Informed traders try to exploit their informational advantage by trading in options instead of the underlying equity.
- Pan and Poteshman (2006) found that stocks with low put-call ratios (on newly opened option positions) outperform stocks with high put-call ratios by more than 40 basis points on the next day and more than 1% over the next week.
- They attribute the phenomenon to non-public information possessed by option traders. They found greater predictability from option signals for stocks with higher concentrations of informed traders and from option contracts with greater leverage.
- A hypothetical portfolio that goes long the stocks of the 20 percent of options with the lowest put-call ratios, and goes short the stocks whose options had the highest ratios, rebalanced weekly, produced an annual average return of 62%. Read here for more info.
Market Impounds Information on Optioned Companies Faster
- Companies with traded options tend to have bigger market reaction to earnings information compared to non-optioned companies. This is because optioned companies tend to be followed by informed traders / investors who would quickly incorporate the latest earnings information into the price.
- Non-optioned companies are usually small-caps which are less followed, so their price adjustment to earnings news takes place over a longer time and tend to have smaller market reactions to earnings announcements.
Market Reactions to Earnings Can Be Unexpected
- The authors measured the return over a 3-day window and a 21-day window. A 3-day window corresponds to holding the stock for day -1, day 0, and day +1, where day 0 is the earnings announcement date, and each day is a trading day.
- Using a data of large-cap stocks that comprise the Russell 1000 index, over the period between 1984 and 2009, the authors calculated the earnings surprise as the difference between announced EPS and the median analyst EPS forecast made in the 30 days prior to the announcement.
- The reaction is defined as the excess return over the market for the same period.
- For positive earnings surprise, negative excess earnings results in ~40% of the time.
- For negative earnings surprise, positive excess earnings results in ~40% of the time.
- For zero earnings surprise, it’s around 50% of the time for each type.
- The results are similar whether they are measured across a 3-day window or a 21-day window.
Pertinent Observations on Implied Volatilities
- Implied volatilities are typically higher than historical volatilities because option sellers ask for protection from black-swan type events.
- Implied volatilities often increase in the periods leading up to an earnings announcement. It then collapses immediately following the announcement (open interest and trading volume drops as well). This does not mean that positions should be opened early because it is balanced by the time decay on the options.
- Implied volatilities tend to be higher in the opening hours of trading, and diminish in the last hour of trading, because market prices needs to digest developments that occurred when the market was closed. Option buyers that wants to close their position should do so during the day instead of at the end of the day.
- Trading volume
- Be cautious when entering orders in contracts that have fewer than 50 contracts trade on an average day.
- Strike price
- At-the-money, if not the closest in-the-money or out-of-the-money contract.
- The delta is near 1 for at-the-money options, so the option price has a high sensitivity to the stock price.
- Expiry month
- Choose contracts in the nearest expiration month, because they have the highest delta.
- If the earnings announcement date is close to the options expiration date, choose the following month to prevent the significant time decay from dampening the large moves in option values that we want.
- An expiry month further out will also allow the flexibility to continue with the option trade.
- Bid-Ask Spread
- A bid-ask spread of 3% to 5% of the price is fairly normal.
- Open the trade on the day before the a company makes its earnings announcement, near market close for the day.
- While opening a trade early benefits from increasing implied volatility, there will be significant time decay that occurs for front-month expiration option contracts.
- Exit the trade the next day, near market close, giving the market at least a few hours to digest the earnings announcement.
- Entering orders
- First try a limit order near the midpoint of the bid-ask.
- Only when that doesn’t get hit, then you offer a better price. Fight for every penny.
- Bull call spread
- Buy a call option, and sell a call that is one (or more) strike prices above the long call position. This reduces the cost of your long position.
- The value of the short out-of-the-money call will decrease sharply after the announcement due to its volatility collapse and its exponentially-fast decay of time value. The short call position can potentially be left open after the announcement if it is extremely unlikely that the price will reach there in time.
- A more aggressive trader can short more higher strike calls.
- Bear put spread
- Buy a put option, and sell puts that are one (or more) strike price below the long put position.
- Directional bets are difficult because it is hard to predict the direction of the market reaction.
- Buy a call and a put at the same strike, very close to at-the-money.
- Buy a out-of-the-money call and a out-of-the-money put.
- A strangle is cheaper than a straddle because both options are out-of-the-money.
- If a stock’s movement is sufficiently large, the winning side of the straddle almost always makes much more profit than the loss incurred by the losing side. If the price movement is small, the loss on the losing side due to volatility collapse outweighs the profit on the winning side.
- Be careful of overpaying for the options. If their implied volatilities are too high, it is difficult for the strategy to be profitable.
- Short iron butterfly
- It is straddle consisting of a bull call spread + a bear put spread.
- Short iron condor
- It is a strangle consisting of a bull call spread + a bear put spread.
- Short straddle and short strangle
- If you think that the market reaction will be muted, you can open a short straddle or short strangle position.
- A short position benefits from the volatility collapse after the announcement, and also the time decay in the option values. Note that sometimes an announcement may add new uncertainty, so the volatility collapse may not materialize.
- Non-directional bets work better on smaller companies because the market reaction tends to be larger, however smaller companies tend to have less liquid options.
Market Reacts Stronger for Growth Stocks
- Skinner and Sloan (2002) analyzed market reactions for growth (high P/B) and value (low P/B) companies.
- The market tends to react more strongly to earnings announcements from growth companies, compared to value companies.
- For a value company, on average, the market reaction to good and bad earnings have the same magnitude.
- For a growth company, on average, the market reacts much more severely to bad earnings than to good earnings (a.k.a. the torpedo effect). This suggests that a straddle strategy should have a bias on the put side (i.e. a 2-to-1 ratio of puts to calls).
Market Reactions to Revenue Surprises versus Earnings Surprises
- Ertimur, Livnat, and Martikainen (2003) found that the market reacted more strongly to revenue surprises than to expense surprises.
- Earnings surprise negative, revenue surprise positive, market reaction is negative.
- Earnings surprise positive, revenue surprise negative, growth company, market reaction is negative.
- Earnings surprise positive, revenue surprise negative, value company, market reaction is positive.
- Earnings surprises are persistent. Companies that have positive earnings surprise in the past are more likely to positively surprise again in the future, vice versa for negative surprises.
- The probability of a positive earnings surprises increases from 76% to 80% to 82% to 84%, if there were positive earnings surprises in the past 1 quarter, past 2 quarters, past 3 quarters, and past 4 quarters respectively.
- The probability of a negative earnings surprise increases from 48% to 55% to 58.5% to 63%.
Post Earnings Announcement Drift (PEAD)
- Ball and Brown (1968) showed that the market has a strong tendency to extend its reaction to an earnings surprise long after the current announcement, usually for several quarters after the current quarterly announcement.
- A disproportionate fraction of the drift is concentrated around future earnings announcements (i.e. repeatedly surprised in the same direction).
- PEAD occurs mainly in highly illiquid stocks, stocks with high transaction costs, and is larger for stocks that announce earnings on days when many other stocks also announce earnings, and is smaller for stocks that have abnormally high options trading volume pre-announcement.
- Proprietary traders open options positions that take advantage of the momentum while individual investors tend to do the opposite.