Playing Company Announcements
Catching a big price move is an option buyer's dream from the time that we first learn about options and how they can be used to speculate. The combination of limited risk and unlimited potential was – and still is for many – the main attraction of using options.
I have devoted a significant amount of time over the years to researching company announcements – how to anticipate them and how to profit from the sudden stock price moves that sometimes follow them. I have been interested in earnings announcements, FDA announcements, any kind of announcement that could move the stock. The bigger the potential move, the better.
The strategy of choice in these kinds of plays is simply to buy options – either just calls, just puts, or both. Nothing more complicated than that. If I want to cash in on a big move, there is no point in using a strategy that limits my returns. However, since there is a possibility of losing the whole investment, only a small amount should be invested in any one trade. I have mainly used OTM options because of the greater leverage. As a result, when the trade does not work out the whole investment is usually lost.
Naturally, options are more expensive when everyone knows that an important announcement is coming. Even so, it can be worth it to buy a few. Do this enough times – over a broad selection of different stocks in different kinds of situations – and you should find that the few good trades more than make up for the many losing trades.
The best opportunities are often among the pharmaceuticals and biotechs. Company or FDA announcements can make these stocks jump, in most cases, farther than the option volatilities would have indicated they should prior to the announcement. It would not be unusual to see a pharmaceutical stock double on the release of good news. I have seen instances after the FDA approved a new drug when the out-of-the-money (OTM) calls went from 0.30 to 30.00 that day – 100x your money! Positive outcomes in other trades I have followed yielded anywhere from 44x to 1.0x (breakeven).
Here are a few observations I have put together from my research on this subject:
1) Unusual call volume prior to an earnings report is an unreliable indicator of what will happen to the stock after the earnings report.
2) If a horizontal IV skew is evident (showing that everyone knows something is coming) prior to an earnings announcement, the results are more positive. In fact, I would say that the presence of an IV skew is an essential element when selecting the best opportunities.
3) If there is unusual call option volume but no horizontal IV skew, and there is nothing special in the news, nothing good usually results from it.
The signs that the marketplace is aware of an impending announcement coming are 1) the presence of horizontal skew (different IV levels from month to month) and 2) a high IV/SV ratio.
Let's discuss horizontal skew a little bit first. Options will naturally have extra high premiums when the marketplace is expecting an announcement that could move the stock in a big way one way or the other. Options expiring after (and closest to) the date of the expected announcement will be priced the highest.
For instance, if an announcement is expected in the next few days and the nearby options have at least a few days of life left, you will normally see that the nearby's have the highest IV. Following that, options in the 2nd month and after will have progressively lower IV's. It is rational for the market to price options this way because after any possible jump in the near term the stock should then return to normal price behavior.
Horizontal skews like this beg the trader to enter into calendar spreads – selling the expensive nearby options while simultaneously buying the cheaper farther-out options. However, the prospect of a possible stock price jump should give the trader pause because a sufficient move in the underlying will ruin the prospects for any calendar spread. In short, calendar spreads are being priced to handicap the trader who wants to bet that the stock does not move much.
An interesting horizontal skew exists when a company's announcement is not expected for a few months. In a case like that, the options expiring after (and closest to) the date of the expected announcement will still be priced the highest, while options in the succeeding months will have progressively lower IV's. Options in the preceding months will have normal IVs.
A high IV/SV ratio is another sign of a pending announcement. When the marketplace has assessed the potential impact of a coming announcement as being significant, it prices that stock's options at an IV that is way above the average SV.
When to Get In
I have not found a reliable pattern to help me know when it's the best time to "buy my tickets". From experience, sometimes it was best to buy in early because the options gradually became more and more expensive right up to the time of the announcement. In other cases, brief periods of excitement – when the options were extremely expensive – were followed by slack periods when the options could be bought for much less. So it's arbitrary. I have often bought a few options early on, and then bought more if I saw the price drop to less than half of what I paid before.
When to Get Out
Based on what I've seen, the best time to sell is any time between the afternoon of the 1st day (the day of the announcement) to late on the 6th day (that's trading days; not calendar days). Watch the news for any further announcements – such as brokerage upgrades – that might help propel the stock higher for a few days. Nevertheless, have your finger on the trigger, ready to sell. A trailing stop is recommended.
Difficult to Find News
I must say that it is difficult to find out the date or any other information about upcoming announcements on pharmaceuticals and biotechs. Sometimes all you have is the options market to tell you that something is going to happen. On many, I have not been able to determine, from Yahoo Finance or any other news site, what kind of announcement is expected, nor the projected date of the announcement. I have also scoured the FDA's official site for anything like a docket. No luck there.
If anyone knows about a reliable source, I would enjoy hearing from you. Meanwhile, I have to admit that sometimes I'm trading in the dark. However, while it's nice to know the date and what kind of announcement is expected, when you think about it, that's not essential information. I have found that it's next to impossible to predict the magnitude of the potential move even when you know the nature of the announcement. Sometimes just an FDA letter that says a drug is on the "fast track" moves a stock more than an actual FDA phase III approval. You just never know. Although, if the announcement concerns a company's sole product, you can bet that the stock will make a big move.