Earnings And Options: A Risky But Lucrative Relationship

North American companies listed on a stock exchange report their earnings results every quarter. Options investors view this event as an opportunity to reap large returns if a stock moves dramatically in one direction or another.

Earnings Move Stocks

Companies must release information on their earnings to investors on a regular basis. This includes key metrics, like revenue, margins, profit, and more. Companies typically offer a deep-dive in their earnings that provides investors with a better snapshot of individual business units, product lines, or geographic regions.

The purpose of an earnings report is to keep investors up to date on the company’s performance. Leading into earnings season, analysts spend a considerable amount of time and effort trying to predict the figures that will be shared in a company’s report.

Some of the ways analysts become better informed include talking with major customers and surveying consumers to better understand their spending habits and intentions. The collective wisdom of multiple analysts covering a company is known as the “consensus estimate.” 

If a company dramatically misses the consensus estimate, the stock is likely to fall hard and fast. A major shortfall typically implies that the company’s prior valuation was overly generous. On the other hand, a company that surprises on the upside will see its stock rise as investors quickly realize that they were undervaluing the company.

Options as a Hedge

Investors can buy a put option ahead of an earnings release if they want to protect their stock against potential downside movement. If the investor is right and the stock loses value, the put option will rise in value, thereby drastically minimizing the investor’s loss on the stock.

If the investor is wrong and the company releases acceptable or good earnings, the value of the put option will expire worthless. For many investors, this is a reasonable proposition, as a relatively small investment in an option can protect against a huge downside move by a stock.

Other investors may want to forego hedging their position with options because they are bullish on the stock’s long-term outlook. Everyone understands that a company may struggle in the near term, for reasons such as a marketing campaign isn’t as effective as it should have been, or supply constraints that have limited sales. 

These investors don’t feel the need to protect their stock on the downside because they plan on remaining a shareholder for years, perhaps even decades.

Options Can Deliver Big Rewards

Investors who are confident a stock will experience a sharp movement in either direction could generate a large profit through options. While this phenomenon is rare, some stocks may move 20% or more in the wake of an earnings release, and the corresponding impact on the options will be outsized.

The exact amount that an option price will move will depend on multiple factors, in particular the strike price and time to expiration. As such, simply being on the right side of an options trade does not guarantee that you will earn a profit. But if an option investor’s prediction is accurate, the position could soar 100% or more in a short period of time.

Beware of the Risks

Trading options around earnings releases poses a high level of risk that conservative investors may find unreasonable. For example, if a stock moves lower on a poor earnings report, it could take several quarters or even longer for the company to convince investors to invest in the stock again. Investors holding a call option face slim chances of seeing their holding turn a profit, even if there is a considerable amount of time left until the option expires.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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