What Are Earnings?

Earnings refer to after-tax net income, and earnings announcements are a major catalyst for stock movement. Earnings and the circumstances relating to them can indicate whether the business will be profitable and successful in the future. The earnings report is a key way for a publicly traded company to explain how it is performing. Companies are legally required to file quarterly earnings reports (10-Q), and an annual report (10-K) with the SEC. Companies typically also post a press release to the general public summarizing what is found in the 10-Q. The press release is a very high-level summary of the information found in the 10-Q, providing some key financial performance statistics such as revenue, net income, cash flow, earnings per share and Earnings Before Interest and Taxes (EBIT). Earnings press releases often provide key insights and guidance from management about the company’s future prospects, which can also dramatically affect stock price movement.

Corporate earnings, and the time around earnings announcements is one of the most important events for many options investors. It is not unusual for the company’s stock price to rise or fall dramatically in the days immediately around an earnings report. This potential for a large stock movement, and increased stock volatility, can create lucrative trading opportunities.

Earnings Announcements

An earnings announcement is typically made on a specific date during earnings season. Preceding an earnings announcement, speculation and hedging activity will accelerate. The options volume and open interest typically steadily increase leading into the earnings announcement and investors with different expectations can cause various options, expiration dates and strikes to trade more erratically. The option markets start to form a picture of the different investor viewpoints that can be observed in the option chain. The premiums paid for an option will reflect the probability assigned to that strike being profitable by expiration.

Future earnings dates, both announced and projected are often compiled in comprehensive tables with filters that allow investors to search based on date, stock type, and many other variables.

How to Trade Options Around Earnings

In general, a stock's implied volatility will rise as it heads into earnings. This happens because there is a lot of uncertainty (or risk) around what may happen during the earnings announcement. Thus, impending earnings announcements cause option premiums to rise, for both puts and calls.

Once the earnings are announced, volatility typically drops, and regresses back toward its historical mean value. This "volatility crush" also causes option premiums to decline at all strike prices and expire dates. Knowing this, investors who wish to speculate on earnings will focus on option strategies in which they are net sellers of options to capture the higher premiums. The primary strategies are typically multi-leg and include: straddles, strangles, spreads and collars. Some investors will use options as protection or hedge, to reduce risk in existing positions before an earnings announcement.

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