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Option Strategies for Earnings Announcements: Opportunities and Risks

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Because earnings announcement trades involve transacting around a short, well-defined window of time, they can, when properly implemented, produce positive returns regardless of the market environment. The authors explain the opportunities and risks around earnings announcements.
This chapter is from the book

In today’s topsy-turvy investing environment, a crisis (real or imagined) is always just around the corner. Just as we’re licking our wounds from a prior crisis, there is a larger one looming on the horizon. How do you navigate through this turmoil? We propose event-driven trading—because in many ways it steers clear of general market movements and can even strive in them. Our favorite type of event is the quarterly earnings announcement. Because earnings announcement trades involve transacting around a short, well-defined window of time, they can, when properly implemented, produce positive returns regardless of the market environment. (They’re almost market neutral in this respect.) In this chapter, you’ll discover why trading around earnings announcements has potential, and what features these trades possess that make them more desirable candidates for options trading than other events (like, for example, dividend change announcements). Do earnings announcements garner a sufficient market reaction to be worthy of event-driven trading? What are earnings surprises? More importantly, do the market reactions “match up” (in direction and magnitude) to these earnings surprises? How can options-based trades complement the features of these earnings-related events? These are some of the questions we answer in this chapter.

Earnings Announcements: Major, Recurring Events

Corporations make many public disclosures during any given year. Mergers and acquisitions, change of board directors, insiders’ trading of stock, and dividend announcements are all examples. However, most of the disclosures are not recurring and their timing is hard to estimate. Moreover, the impact of most disclosures on share prices is small or nonexistent. The type of disclosures that are desirable for an event-driven investor are recurring, have a predictable schedule, and have a potentially sizable impact on share prices. A disclosure that meets all these requirements is the quarterly earnings announcement.

The Securities and Exchange Commission (SEC) requires all publicly traded companies to file quarterly 10-Q financial reports. Most companies announce their quarterly performance a few weeks before the 10-Q is filed with the SEC. These quarterly announcements are typically referred to as the firm’s earnings announcements because earnings per share (EPS) is the number contained in the announcement that everyone is most paying attention to. These regularly recurring earnings announcements are by far the most salient, most anticipated, and most reliable news that companies publish. It is the most-watched piece of information that comes directly “from the source”—the company itself. It’s no wonder that these earnings announcements move prices.

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