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Preface to Option Strategies for Earnings Announcements

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The authors of Option Strategies for Earnings Announcements: A Comprehensive, Empirical Analysis explain how by trading on corporate earnings, investors can reliably profit in both up and down markets, while avoiding market risk for nearly the entire quarter.
This chapter is from the book

Preface

Do you find yourself intimidated by stock market volatility? If so, you are not alone. Nowadays, more and more investors are intimidated by the volatility that has become the norm. After the crash in 2008, the next three years were characterized by extremely bumpy rides as well. In 2009, you saw your stocks tank by 20% in a little over two months. Just as you completely lost faith in the equity market, one of the most spectacular rallies in history began. In both 2010 and 2011, you enjoyed a strong rally in the first few months of the year, and then, all of a sudden, the market was plagued by deep worries about the European debt crisis and the prospect of global economic recession or worse. Major indices lost 20% and the bears predicted bigger disasters to come. Facing this crisis, central banks started pumping liquidity into the economy. While pundits warned that central banks were going to fail miserably and hyperinflation was just around the corner, the market roared back. In short, it takes a very strong stomach to bear these market swings. Not surprisingly, many are bailing out of stocks and rushing into bonds, despite the fact that bond yields are incredibly low and the prospect of any rise in inflation could easily cause significant damage to bond investors.

You are facing a dilemma: You despise high volatility in the stock market and yet you fear the rich valuation of the bond market. What should you do? One of the solutions is to invest in absolute return strategies that are more or less independent of (the direction of) market movements and the state of the economy. For instance, event-driven strategies design investments around mergers and acquisitions or other specific events and actions. Because the returns of event-driven strategies depend mostly on the outcome of the events targeted, such strategies are relatively neutral to the general market.

This book introduces an event-driven strategy centered on the most salient and regularly recurring corporate event, the quarterly earnings announcement. The trading strategy recommended involves financial derivatives. Not all derivatives are evil and dangerous. In fact, many offer you better risk management and opportunities not available in the cash market. For example, in the stock market you can buy a stock if you are bullish and short it if you are bearish. However, what can you do if you think the market’s reaction to an upcoming earnings announcement will be large but you cannot decide which way it will go? You cannot buy the stock and sell it short at the same time, but you can express such a view in the options market by buying call and put options at the same time (i.e., long a straddle or strangle).

Trading opportunities around earnings announcements, including straddles and strangles, were examined at length in our previous book, Trading on Corporate Earnings News. However, we did not document the profitability of the strategies using a large population of real trading data. Like many other trading books, we provided examples, but we did not present the results of tests that showed how profitable (or unprofitable) a strategy might be when applied to a broad base of many securities. So this is the first important contribution of this new book. No prior options book has provided this information. We analyze the full universe of all equity options contracts traded over 14 years from 1996 to 2009, examine the data on literally millions of observations (gigs and gigs of data), and report to you the objective, empirical results. No more cherry-picking of good results and brushing aside of bad results. We present to you the full distribution of historical returns on option strategies around earnings announcements, so you are fully informed. That is a significant amount of data that you would never have the time (or desire) to pore over yourself. We help you rise above the din, and boil this data down to powerful information. In easily understandable tables, we arm you with the knowledge of how various options trades fare on an empirical basis.

Have you had the general sense that, say, short near-the-money straddles, entered a day before earnings announcements and exited the day after earnings announcements, were a winning play? Well, no more guessing or having a general sense. Our conservative analysis shows that short straddles had a median two-day return of 1.93%. That’s a significant return for two days. However, the mean two-day return was in fact negative, –3.83%. This suggests that well over half of the short straddles were winning plays (given that the median is positive), but that a few large losing trades brought down the average returns, perhaps not surprising given that short options strategies have a fat left tail. But what is this information worth to you—the fact that the median returns are 1.93%, as opposed to some general sense of value? There’s a huge difference in a positive return of approximately 0.1% versus perhaps 10% versus...exactly 1.93%. And wouldn’t you like to know what percentage of all such trades are winners? We know that it’s more than 50%. But is it 51% or 80%? (We’re not telling you just yet.) Is it enough for you to know that the overall median returns were 1.93%? Or would you like to know how the strategies fared in certain industries and certain years? A short straddle entered in the manufacturing industry in a boring, uneventful year like 2005 is probably different from the same strategy for a financial firm in 2008 and 2009. We document these differences to inform you about how options-based strategies fare in different industries and different years. This precision in information is what we aim to offer the careful reader. It helps arm you with knowledge that enables you to fully understand the odds of your trade being profitable based on real historical data.

The second purpose of this book is our presentation of what-if scenarios. In each chapter, you will find a specific options strategy. Our baseline analysis is always of at-the-money or near-the-money options with the closest expiration date. We also set a standard holding period of two days. Though this baseline analysis is certainly interesting, a natural question that arises is how the distribution of returns would differ if the trades were executed using a different strike price, or a different expiration month. How would the trades differ if we extended the holding period? We answer all of these questions in our extended analysis by presenting each of these alternative what-if scenarios. This enables you to make your own judgment about the types of trades you want to put on, as well as the particular features of trades that you like or don’t like, and what is more profitable versus not. These robustness tests also further ensure that our baseline results are not some empirical anomaly.

Also, there are several ways of exploiting earnings announcements. For instance, we can consider three general time-related windows around the announcements. The most straightforward is the two-day window capturing the actual announcement. However, we also examine potential trades that occur days or weeks before the earnings announcement, to potentially exploit the buildup of implied volatility before the earnings announcement. And we examine separate trades entered after the earnings announcement, to potentially exploit possible post-earnings-announcement drift. Each of these three trading windows—before, during, and after the earnings announcement—presents its own features and each deserves separate analysis.

The third feature of this book is that we explore ways to systematically improve the profitability of the general strategies. Put differently, we design a quantitative process to enhance security selection. For example, in stock investing, researchers have long documented that stocks with low price-to-book ratios tend to beat the overall market by a large margin in the long run. Therefore, low price-to-book ratio is a quantifiable characteristic that you might prefer. This book’s approach is similar to what other researchers have done for stock investing. We look for quantifiable characteristics that can potentially help you select better candidates for your option strategies. For example, should you buy straddles with higher or lower implied volatility before earnings announcements? Is there information in historical earnings announcement returns? Should you focus on large or small companies? Does the valuation of the company matter? What is the effect of the industry that the company belongs to? These are all important questions which we provide answers to. Armed with such information, you will be able to enhance the returns of your option strategies significantly.

The book is divided into three parts. In Part I (Chapters 1 to 3), we lay down the foundational work by explaining the unique features of earnings announcements, the structure of the analyses, and the important issues related to the liquidity of options, measured by bid-ask spreads. In Part II (Chapters 4 to 9), we present the results of the general strategies including both directional and volatility trades, as well as trades before and after earnings announcements. In Part III (Chapters 10 to 15), we explain and analyze factors that can improve your security selection process. In the final chapter (Chapter 15), we present enhanced strategies that exploit each of these factors simultaneously.

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