Exploiting Earnings Volatility: An Innovative New Approach to Evaluating, Optimizing, and Trading Option Strategies to Profit from Earnings Announcements

268 Pages·2015·17.41 MB·English

by  Brian Johnson

Exploiting Earnings Volatility:

An Innovative New Approach to Evaluating, Optimizing, and
Trading Option Strategies to Profit from Earnings
Announcements

Brian Johnson
Copyright 2015 Trading Insights, LLC

All rights reserved. Except as permitted under the U.S. Copyright Act of
1976, no part of this publication may be reproduced, distributed, or transmitted
in any form or by any means, without the prior written permission of the
publisher. This e-book is licensed for your personal use only. This e-book may
not be resold or transferred.

Disclaimer: Information in this e-book and in the accompanying
spreadsheets is provided solely for informational and general educational
purposes and should not be construed as an offer to sell or the solicitation of an
offer to buy securities or to provide investment advice. Option trading has large
potential rewards, but also large potential risk. You must be aware of the risks
and be willing to accept them in order to invest in the options markets. Do not
trade with money you cannot afford to lose.
Dedication

To my former derivative students, whose desire to learn and seemingly limitless
supply of insightful questions fueled my enduring fascination with options and
inspired many new research ideas.
Table of Contents

Copyright 2015 Trading Insights, LLC
Dedication
Introduction
Tips on Viewing Images
1 - Volatility Review
2 – The Aggregate IV Formula
3 – The Basic Spreadsheet
4 – True Greeks
5 – UA Earnings Strategy
6 – Integrated: Input & Import
7 – Integrated: Volatility Model & Simulation
8 – Integrated: Optimization & Analysis
9 – CREE Earnings Strategy
10 – Practical Considerations
About the Author
Resources
Introduction

Brian Johnson, a professional investment manager with many years of trading
and teaching experience, wrote his first book, Option Strategy Risk / Return
Ratios: A Revolutionary New Approach to Optimizing, Adjusting, and Trading
Any Option Income Strategy in 2014. It has been one of the top-selling option
books and it has received outstanding reviews by the option trading community.
His new book, Exploiting Earnings Volatility, introduces an innovative new
framework for evaluating, optimizing, and trading option strategies to profit
from earnings-related pricing anomalies. Leveraging his extensive background
in option-pricing and decades of experience in investment management and
trading, Brian Johnson developed this inventive approach specifically to design
and manage option earnings strategies.
These revolutionary new tools can be applied to any option earnings strategy
on any underlying security. In an Active Trader article titled “Modeling Implied
Volatility,” Mr. Johnson introduced a formula for aggregating discrete volatility
measures into a single metric that can be used with conventional option pricing
formulas to accurately model implied volatility before and after earnings
announcements. The practical application of this formula has profound
implications for option trading and strategy development.
Exploiting Earnings Volatility is written in a clear, understandable fashion
and explains how to use this revolutionary approach to 1) solve for the expected
level of earnings volatility implicitly priced in an option matrix, 2) calculate
historical levels of realized and implied earnings volatility, 3) develop strategies
to exploit divergences between the two, and 4) calculate expected future levels
of implied volatility before and after earnings announcements.
Furthermore, Exploiting Earnings Volatility also includes two Excel
spreadsheets. The Basic spreadsheet employs minimal input data to estimate
current and historical earnings volatility and utilizes those estimates to forecast
future levels of implied volatility around earnings announcements.
The Integrated spreadsheet includes a comprehensive volatility model that
simultaneously integrates and quantifies every component of real-world implied
volatility, including earnings volatility. This powerful tool allows the reader to
identify the precise level of over or undervaluation of every option in the matrix
and to accurately forecast future option prices and option strategy profits and
losses before and after earnings announcements.
The Integrated spreadsheet even includes an optimization tool designed to
identify the option strategy with the highest level of return per unit of risk, based
on the user’s specific assumptions.
Written specifically for investors who have familiarity with options, this
practical guide begins with a detailed review of volatility, the single most
important (and often misunderstood) component of option pricing. The
aggregate implied volatility formula is fully explained in Chapter 2, which also
includes graphical examples to communicate the mathematical relationships
visually and intuitively.
Chapter 3 includes a detailed step-by-step guide to using the Basic
spreadsheet to calculate historical and implied levels of earnings volatility and to
forecast future levels of implied volatility before and after earnings
announcements.
The next chapter provides a conceptual and mathematical explanation of
“True Greeks,” accurate measures of risk and return sensitivity that reflect the
real-world behavior of options. New option Greeks that are specific to earnings
announcements are also introduced in this chapter. The Integrated spreadsheet
calculates “True Greek” values for individual options and for option strategies.
Building on the above foundation, Chapter 5 includes a trade example that
uses actual market data and analytical results from both spreadsheets to design a
unique option strategy to exploit earnings-related pricing and volatility
anomalies.
After illustrating the capabilities of the spreadsheets in a real-world trade
example, Chapters 6 through 8 explain every module of the Integrated
spreadsheet tool and how to best use this spreadsheet in practice: how to import
the data, enter user specifications, solve for volatility parameters, and optimize
and evaluate option strategies. The data for a single underlying security and its
option matrix with actual prices are used in both spreadsheets and throughout
these chapters to demonstrate the process traders would employ in a real-world
environment.
The next chapter includes another real-world trading example with actual
market data, which illustrates how the analytical tools in this book can be used in
different market environments. The final chapter examines practical
considerations and prospective applications of these innovative new tools.
This book introduces a new analytical framework that may sound
complicated at first, but is really quite intuitive. Formulas are provided to ensure
an accurate mathematical description of the analytical framework. The formulas
presented in the book are limited to basic high-school algebra, so they should be
accessible to most readers. However, for those readers who still have nightmares
about high-school algebra, important mathematical relationships are also
explained intuitively and depicted graphically.
Most important, you will not need to perform any of these calculations
manually. Exploiting Earnings Volatility includes a link to Excel spreadsheets
that perform all of the calculations described in the book. In addition, the
Integrated spreadsheet functions are all automated and accessible via
“push-button” macros.
All of the formulas in the book are presented in Excel format to make it
easier for readers who would like to experiment with these tools in their own
Excel spreadsheets.
The unique price and volatility behavior of options before and after discrete
earnings announcements is an enigma to most option traders, even to many
professional option traders. The aggregate volatility formula is relatively simple,
but it has profound implications. When integrated with a real-world volatility
model, it offers unparalleled insights into earnings volatility, price behavior,
option strategy construction, and prospective value-added opportunities.
Tips on Viewing Images

The ability to examine the graphs and tables in this book is essential to
understanding the material. Depending on the screen size of your E-reader, it
may be difficult to see all of the detail on the images. Many of the images have a
landscape orientation, but most users prefer to use the portrait orientation when
reading. As a result, many of the images will be compressed to fit the narrower
width of the screen.
The larger images all appear at the top of a new page. The easiest way to
enlarge these images is to simply rotate your E-reader 90 degrees from portrait to
landscape orientation. However, the screen orientation on your E-reader must
first be unlocked.
If you would like to examine the graphs and tables in even greater detail, first
select the image (for example, tap twice on the image with the Kindle Fire). This
would bring up the graphic on a separate screen. You would then be able to
zoom in on the graph or table. Close the image screen when you are finished and
continue reading.
1 - Volatility Review

Option pricing before and after earnings announcements is highly inefficient and
the mechanics of calculating the corresponding implied volatility values is a
mystery to most market participants. As a result, for traders with the proper tools
and an understanding of earnings volatility, option earnings strategies represent
one of the best and most reliable sources of value-added opportunities in the
option market. Even better, these opportunities occur every quarter and there are
hundreds of individual stocks that have options with sufficient liquidity to
exploit these opportunities.
Until now, there has never been a consistent, objective framework for
evaluating and constructing option earnings strategies that simultaneously
models every aspect of volatility, including earnings effects. This book will
provide the tools you need to objectively evaluate and develop option earnings
strategies on any underlying stock, in any market environment. However, before
I introduce these new tools, we need to examine volatility and how volatility
affects option values. The key to understanding option valuation is the
asymmetrical payoff function. Portions of the following crucial section also
appeared in my first book: Option Strategy Risk / Return Ratios.

Asymmetrical Payoff Functions

Call and put options have asymmetrical payoff functions. This sounds
complicated, but is actually relatively straightforward. A call option gives the
owner or buyer the right, but not the obligation, to purchase the underlying asset
at the strike price on or before the expiration date. For now, let’s keep things
simple and ignore the fact that many options can be exercised prior to expiration.
This will allow us to focus our attention on what happens at option expiration.
The following example (depicted in Figure 1.1 below) should help illustrate
the concept of asymmetry. If we purchased a one-year call option on IBM with a
strike price of $100, we would only choose to exercise the call option if the price
of IBM was above the $100 strike price (in the money) on the expiration date.
If the price of IBM was $110 on the expiration date, the payoff would be
$10. The payoff is also called the intrinsic value and represents the value of
exercising an in-the-money option at expiration. In this case, we could purchase
IBM for the $100 strike price and immediately sell it at the market price of $110
for a payoff of $10. If the market price of IBM was $120 on the expiration date,