The earnings announcement is a critical event for any company. Immediately after the announcement, the stock price can surge or fall significantly depending on how strong and expected the results are. Therefore, one of the speculative strategies for trading on the stock market may be to buy short-term Call or Put options based on the stock price movement direction that an investor predicts. This is a high-risk strategy that can bring both multiple returns and large but limited losses.
The option should be purchased a few days before the earnings announcement, and sold on the day of the release. The main movement in the stock price occurs on this very day, so there is no point in holding options until the maturity date.
Some statistics
We collected statistics on companies with market capitalization over $1 billion (2,140 companies) and estimated the impact of their Q4 2023 financial results on their stock price performance on the day following the date of their financial statements release. Based on these statistics, about 23% of stocks increased by more than 5%, while 19.4% of stocks lost at least 5%. Thus, more than 42% of the companies showed increased volatility during earnings release. Below is the chart showing the stocks’ return distribution on the day following the earnings release date.
Option selection method
It makes sense to apply the strategy of buying stock options prior to earnings announcement only if you expect a sharp change in the asset price. This strategy is ineffective when the stock price volatility is low.
Before making a decision on whether to use the strategy, an investor needs to forecast in which direction the stock price is likely to move and by what approximate amount. An investor can buy a Call option if they believe that the price of the selected asset will increase after the earnings announcement, or a Put option if they assume that the stock price will go down.
Then you need to select the option’s expiration date and strike. After that, we recommend calculating the following metrics:
- The minimum option return required to reach the breakeven point;
- The expected return on the option.
If, in your opinion, the breakeven point is an achievable goal on the date of earnings announcement and the expected return on the option suits you, then it makes sense to go ahead with the deal.
Below are our recommendations for selecting expiration dates and strikes for Call and Put options, as well as the methodology for calculating the key metrics.
For Call option:
Expiration date: Short-term option with an expiration period of 1–4 weeks
Strike: Nearest strike, above the current stock price by no more than 5%
Breakeven point: strike + option price
Minimum return required to reach breakeven point: (strike + option price)/current stock price - 1
Expected option return: (expected stock price post-earnings - strike - option price)/option price
Example calculation:
- Stock price: $99
- Call option price: $1.5
- Strike: $100.
- Expected stock price post-earnings: $104
- Breakeven point: $101.5
- Minimum yield required to reach breakeven point: 2.5%
- Expected option yield: 67%
For Put option:
Expiration date: Short-term option with an expiration period of 1–4 weeks
Strike: Nearest strike, below the current stock price by no more than 5%
Breakeven point: strike - option price
Minimum return required to reach breakeven point: (strike - option price)/current stock price - 1
Expected option return: (strike - option price - expected stock price post-earnings)/option price
Example calculation:
- Stock price: $96
- Put option price: $1.7
- Strike: $95.
- Expected stock price post-earnings: $91
- Breakeven point: $93.3
- Minimum return required to reach breakeven point: 2.8%
- Expected option yield: 35%
Important!
Options must be purchased with a limit order. Buying an option contract with a market order can result in extremely unfavourable prices.
This is a speculative investment idea which carries increased risks. Investing in options can provide a 50%, 100%, 200%, and in some cases even higher returns, but also can lead to a complete loss of the amount invested! In cases where volatility is low, profit or loss can vary between 20% and 30%.
A prudent approach to implementing option ideas is to invest a small portion of the portfolio in many such cases. In this way, losses from unsuccessful ideas will be compensated by high returns on successful investments.
Risks
If an investor makes a mistake in his forecast and incorrectly predicts the direction of the stock price movement following earnings release, the option they bought may significantly depreciate. In the event of a strong stock price change in the opposite direction to the investor's forecast, the option value may decrease by 50%–80%.
Even if an investor correctly predicts the direction of the asset price movement, but the stock price volatility is low, the option value may still decrease by about 30%.
* Your capital is at risk.
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The information provided here should not be considered as a call or offer to buy or sell any financial instrument or to participate in any trading strategy.
Freedom Finance Europe Ltd. is an official Cypriot financial company that has been granted the right to provide only financial services based on the CySEC CIF 275/15 license from 20.05.2015 in the territory of the European Union.
Ownership of securities and other financial instruments is always associated with risks: the value of securities and other financial instruments can either increase or decrease.
Past investment results do not guarantee future returns. The company does not provide or promise future investment income, does not guarantee the reliability of potential investments, and the stability of income size.
* The presented material is a means of marketing communication and cannot be considered as investment advice or investment research. You should do your own analysis before making any investments. If necessary, you should seek independent advice from a certified investment specialist.
