Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Last week we wrote this issue would offer some specific trade suggestions from our rankers and scanners. However, that was before realizing fourth quarter earnings were about to get underway and the time has come to update Volatility Kings our list of companies having a regular tendency to experience increasing option implied volatility as their quarterly reporting dates approach reflecting greater uncertainty or the width of the possible stock price distribution on the report date.
The degree of uncertainty for the current reports may not be comparable to previous quarters. Indeed, some companies are on the list one quarter and not the next while others seem to remain on our list quarter after quarter. Since the focus is on earnings, others with high-implied volatility due to takeover speculation or FDA announcements do not appear along with those lacking sufficient liquidity due to low option volume.
As they say, Volatility Kings “will drill down” into the details.
The search begins for stocks with prices greater than 5 since when prices are too low, there are usually not enough strike prices or liquidity for spreads or other strategies, with the possible exception of short puts that come with assignment risk.
Next, in order to focus on those with the best options volume and liquidity, both the weekly and month average volume requirement is greater than 20K contracts.
The volume requirement may result in being included one quarter but not the next. However, the objective is to find those stocks with sufficient options liquidity and therefore reasonable bid/ask spreads to use for various multiple leg strategies, such as Calendar Spreads, Butterflies, Iron Condors and others.
The volume search begins at the “Top 200 stocks by volume / open interest” link on the left side of the ?Rankers and Scanner? section about two-thirds of the way down our home page where we feature a complimentary ranker sample of the top 200 stocks and ETFs by Options volume and Options open interest displaying weekly averages.
Then the Implied Volatility differential from last quarters? earnings announcement high to the subsequent after reporting low needs to be greater than 10%, occurring regularly with some flexibility on the regularly occurring requirement as it may vary due to market conditions and special situations.
For the data table above, descriptions and details for the column headings follow.
Price in column 3, are closing stock prices as of Friday January 6, 2017
Next Rpt in column 4 is the next expected reporting date. They require checking often as these are only estimates and companies routinely change reporting dates. Time in column 5 is the time during the day to expect the report, where B is before the open, A is after close.
Estimate in column 6 is the current consensus earnings estimate per share, also subject to change before the report date. Some may also have higher or lower “whisper” estimates. In addition, stock prices are moving on forward guidance as much or perhaps more than revenues and earnings.
Last Q IV in column 7 is the implied volatility index mean (IVXM) of the puts and calls reached just before the last quarterly report, but may not necessarily be relevant this quarter.
IV Min Ex in column 8 shows the Implied Volatility Index Mean (IVXM) low after the last earnings report making it easier to compare the pre-report high to the subsequent low. The implied volatility of some, depending upon the last report date, may still be declining from their last report.
IV Now in column 9 is the Implied Volatility Index Mean, (IVXM) as of Friday January 6, 2017.
IV Est/Now in column 10 is the ratio of the estimated implied volatility to the current implied volatility based primarily on the high reached the previous quarter. Those with higher ratios have a potentially greater opportunity to increase going into their next report date and many have already started increasing anticipating the next report.
eBay (EBAY) above is a volume criterion exception since the weekly and monthly averages are somewhat less, but the consistent quarterly implied volatility pattern makes it special. The previous earnings reports are marked with arrows.
The implied volatility is now rising once again in anticipation of the next report scheduled for January 25.
Comments and Observations
The typical pattern is for implied volatility to decline for 4-6 weeks after the reporting date followed by a subsequent rise for about 3-4 weeks before the next report, but vary with each having its own somewhat unique pattern.
Events unrelated to earnings reports can also affect implied volatility, such as the S&P 500 Index implied volatility as reflected by the VIX, now at 11.32 near the low of its 52-week range.
To help identify implied volatility highs, lows, and forecast where they may go along with other details, make sure to check the volatility charts at either our complimentary Basic Options or our more detailed Advanced Historical Data pages on our website.
Some Strategy Ideas
Frequently calendar spreads, also called time spreads are used for quarterly reporting by selling the near term option with higher implied volatility and buying the same strike price in the deferred month with a lower implied volatility. However, since this position will have short gamma or the rate of change of delta, any large move of the underlying stock on the report date will result in a loss.
The alternative approach, distinguished by the expiration date of the short option relative to the earnings report date has quite different characteristics.
When the short option expires before the report date, the short option implied volatility is less likely to advance while the implied volatility of the deferred long option, expiring after the report is more likely to advance into the earnings report. In addition, the risk of a harmful stock price gap diminishes by closing the spread before the earnings report release. This strategy depends on closing the position one or two days before the short option expires and is thus, truly a time spread designed to capture time decay of the short front option relative to the long option while any implied volatility advance of the deferred option is a bonus.
Option prices continuously change in response to changing expectations. The higher the uncertainty the more valuable the option, implying there is a much wider distribution of possible outcomes. When they become more predictable, the implied volatilities no longer increase dramatically before the reporting dates, option volume usually declines and they disappear from the Volatility Kings.
Individual investors relying upon the earnings forecasts and playing the expectations game wondering if they may be too high or too low are disadvantaged when anticipating the direction the stock will move after reporting. However, if the implied volatility has risen enough into the report date it may offer an opportunity for a volatility strategy and not rely upon getting the direction right. In addition, since earnings reports reoccur every quarter there may be more than one opportunity, especially for the ones that have a regular pattern of rising into the report dates.