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The Best Way to Play Earnings with Options — with John Shon (transcript)

This transcript comes an interview with John Shon that you can find here.  You can also find our archives of interviews with some of the world’s best investors here.

Announcer: Live from the Internet, it’s Tradestreaming Radio, with your host, Tradestreaming.com’s own Zack Miller.new book by john shon

Zack: Hey, this is Zack Miller. You’re listening to Tradestreaming Radio, the place on the Internet where investors can learn directly from experts.

One thing I’ve found in my individual investing practice, both my own investing and the work I do with clients, is that, although I know basic options strategies, I’ve struggled to really implement them. More than anything, I feel that options are a great way for a lot of investors to lower the risk in terms of playing out a thesis that they have on a particular stock.

The hardest thing to do with options is to pick a direction, and this is what many investors do, is to buy a call or buy a put, and basically say, “I’m making a bet that the stock’s going to go up or down.” It’s (a) very hard to pick which direction, and (b) a lot of times even if we’re right, meaning earnings season is particularly good, there’s some good news out, the stock may not react the way we’re predicting it.

I was really interested to read this book that was put out recently on the FT Press by John Shon, who’s a professor of accounting at Fordham. He has a Ph.D. from University of Chicago at Booth School. He wrote a book along with Ping Zhou called “Trading on Corporate Earnings News: Profiting from Targeted Short-Term Options Positions.” I invited John on to the show today to discuss the book.

What the book does not do is provide an over-arching strategy saying buy this, sell this. What it does do is provide a framework based upon lots of research that Shon has done, as well as a review of all the other research out there on the best ways to use options going into an earnings season.

The short of it is basically to use what’s called a strangle or a straddle. John will describe what that process is. He’ll also, throughout the conversation, provide us with some other insight on how to better our chances of making sure that this strategy is successful. I hope you enjoy it.

You can find this podcast on iTunes. Please come over there and give us a rating or a ranking. Let us know what you think about the podcast and let other people know what you think about this podcast. You can also find this podcast, as well as a transcript and other information about the book and any of our other shows, in our archives on my website TradeStreaming.com. We’ve got lots of information there and always welcome hearing from you. Hope you enjoy the show. We’ll catch you soon.

John: Look, the way that we had written the book was, and hopefully this comes across in the first couple of chapters, that if you’re looking for actionable advice, it’s basically long straddles the day before earnings announcements, and hopefully you’ll get lucky.

What we wanted to do was have the investor walk away after reading the book and actually learn some things that they could take away and apply to other parts of their trading habits. We spent a lot of time in Chapters 2, 3, and 4 really laying down the foundational work. If you’re not into that, then you’re just not going to be into it.

Zack: That’s a great place to start, with the fundamentals. Let’s talk about why earnings announcements and why you focused on those. Why are they so important?

John: Sure. The earnings announcements are important because number one, they’re required by law. They’re governed by the SEC Acts of 1934. You’ve got a lot of litigation surrounding earnings announcements, so you know that they’re credible. Most importantly, from a trader’s point of view, we know that they happen four times a year. These are four times a year when you know they’re going to happen. A vast majority of these firms have a pretty regular schedule for when these earnings announcements are going to come out. In fact, there have been studies that looked at if XYZ Company always announces earnings in the second week of April and they’re behind in that, then the chances are that the more days they’re late, the worse the news is. It’s that kind of regular pattern in announcing earnings that we were really interested in.

Zack: That’s interesting. I have a previous background as a fundamental analyst for a hedge fund, a long-short hedge fund. We did the requisite momentum trading around earnings. Sometimes we won. Sometimes we lost. Trading stocks, specifically. Obviously because we were taking a sided bet to say, “Hey, we think Apple’s earnings are going to be good,” or, “We’re thinking Akamai’s earnings are going to be bad.” I think a lot of it was just noise. Sometimes we got it right. Sometimes we didn’t get it right.

John: Okay, yeah. It goes back to the classic study that was done in 1968 by Ball and Brown. These guys show that if you just follow the direction of earnings after the announcement that there’s something called post-earnings announcement drift. I’m sure you guys didn’t call it that, but that’s basically what you were trading on. What every single study that’s been done by an accountant or a finance guy since then has shown is that this post-earnings announcements drift, this idea that the price continues to drift after the earnings announcements takes place, you just can’t kill this phenomenon. It’s definitely there.

The issue really is with how you define which firms you want to get into. Most people that implement this strategy will look for a certain standard deviation movement. For instance, if Akamai announced their earnings and they beat earnings by 2 pennies or something, and they had a small blip in one direction of their stock price, that is not going to be enough, according to this post-earnings announcements drift, for you to go into it afterward. What you need is a two standard deviation move. To be honest, I don’t remember what it was. Maybe it was one and a half standard deviations.

Zack: That strategy, the post-earnings drift, would mean getting in after a company has revealed its earnings.

John: That’s right.

Zack: And then riding that for a certain period. I guess the weakest strategy is getting in before earnings, trying to take a guess on which direction things are going, right? I don’t know if it’s the weakest, but it’s less formidable.

John: It’s true that you can wait until afterward and then go on the ride afterward. Really, you’re getting so much of the juice from that announcement itself. You can implement both, right? It isn’t that one’s wrong and one’s right. The post-earnings announcements drift is definitely a directional play where you wait till afterward, and then you try to get in and hopefully you can squeeze out a few pennies in movement afterward.

The long straddle play that we talk about in our book is much more about . . . it’s easy. Look at RIM, right? Look at every quarter of RIM. It’s so juicy to get into a 20% downturn and get out the next day. We also mention that you can mix the two strategies. You straddle it the day before, and then when the bad news comes out, you unwind the bad leg and you let the good leg continue to ride. This is kind of a mix of both strategies, if you will.

Let’s look at the RIM example. Let’s say that you did wait for the earnings announcements. You saw that it went down 20%. Then you started shorting it at that point. How many percentage points are you going to actually squeeze out from that point? I haven’t been following it exactly, but I think it drifted another 2%, 3% downwards. Not that 2%, 3% isn’t huge, but it’s really quite small compared to the 20% on the day of.

Zack: Except you know what direction it’s headed in. If you’re in before, you can be completely wrong and then you’re down 20%, right?

John: Well, that’s the point of the straddle, right? The point is that you don’t know which direction it’s going to go.

Zack: More than anything, I think I was illustrating the fallibility of investors trying to just guess a directional play on some of the stock.

John: Yeah. That’s a valid point as well. Our entire point is the idea that, look, 40% of the time, 41% of the time, what you have are earnings surprises. That is, a company steps up to the mic, makes an announcement, and that earnings announcement is actually better than expected. Forty percent of the time when that announcement is made, the market reaction is going to go in the opposite direction. That’s a huge number, right?

We’ve all seen it happen on occasion, but to think that 40% of the time, they step up, they make an announcement. Even if you guessed the earnings announcement correctly, even if you did, no one can do it perfectly. You’ve got these analysts out there that spend so many resources trying to get this right. They can’t get it right. Let’s just say that you have this magic box where you can kind of forecast earnings perfectly. If you could, 40% of the time you’re going to be wrong when you trade it anyway. It’s a huge statistic in and of itself.

Zack: It’s amazing with how much data and information that’s out there that we continuously see earnings surprises. Can you talk about that phenomenon? I know you have a whole chapter devoted to it in the book. Regardless of all the increases in transparency we think of, or the scrutiny of the financial blogosphere, companies and analysts are still considerably off in some of their forecasting.

John: That’s right. Yeah. We really make the point of that in the book. We’ve run some data to look at the volatility in the earnings and the market reactions to them. There’s a really clear argument for saying that the volatility around earnings announcements should be doing down. Just as you’ve said, the amount of information that’s out there in the Internet age, the number of resources that you have, the institutional guys, everyone else that’s hunting down information, that’s trying to squeeze out info, you would think means that when the earnings announcement comes out everyone says, “Well, gee, we knew that.” At least the smart money knew that and put their money in and prices reflected that. In fact, we find just the opposite. In fact, despite the fact that there’s all this information, I’ll call it saturation, even though there is this information saturation, the earnings announcements returns have been getting more and more volatile.

What you’ve got is, number one, you cannot predict the direction of the market movement, the underlying stock price movement, from an earnings announcement. Number two, that price reaction is more volatile than it was before. Both of these together really tell you that if you want to put on a directional play beforehand, go for it. I’m not going to do it.

Zack: Clearly that leads us into the crux of the book. What do you describe as the best play to handle that increased volatility and the inability to forecast the directional play?

John: Because of that, the easiest thing to do, given this idea of volatility and not being able to pick the direction of the stock price, is to put on a long straddle. Straddle is just taking any strike price and longing a call and a put. As you know, a call is a bet on the upside, and a put is a bet on the downside. Basically, you’re betting on large enough movements to make up for the fact that you’re in both positions.

Zack: What are the mathematics? We don’t have to go into the technicalities behind it, but obviously you’re going to get a movement. You may get no move or you may get a strong move in either direction. One of the options is going to have to increase in price faster than the other one decreases in price, right?

John: Not so much faster, but in a large enough amount. Yes, that’s true. If we put on a straddle and it turns out that Walgreens steps up to the mic and makes a real boring announcement that basically comes in on consensus, not just for their current earnings but for all their forecasted future earnings, and the market moves, let’s say, 50 basis points, then this is going to be a losing trade as far as a straddle is concerned. What we’re looking for with a straddle is action. By action, though we haven’t documented it in the current book, we’re currently working on a second book that really crunches more data, you’re going to need at least a 3% movement in the underlying stock price for these straddles to be profitable.

With that said, if you get a less than 3% move, it isn’t that you’re going to lose the entire value of your straddle. You’re going to sell it off at a loss. As opposed to when there is a big enough move, you’re going to find that the straddle was quite profitable.

The point is that these straddles are not going to be profitable 100% of the time. We never say that they will be. You should be very worried if I did say they would be. The point is that the number of profitable ones, when they’re profitable, they can be quite so, versus when they’re unprofitable, you’re going to take a hit but not a big one.

Zack: You also recommend near-dated options, too, right? You’re sort of racing the clock as well.

John: That’s right. You definitely are.

Zack: Can you talk about that sort of feedback loop?

John: Sure. As you know, two of the main components of an option are its intrinsic value, how close it is to the strike price, and the time value. We suggest you put on these straddle positions in the front month, meaning in options contracts that are closest to expiring. We suggest you do so because these have the most delta, the most price action. You’re going to see the most price action take place for these front-month contracts. That’s the good news.

The bad news is that because there’s so little time left, you’re going to find that the amount of time decay, the amount of value that the option loses due to it getting closer and closer to expiration, is the worst, the most disadvantageous to you as a trader.

It’s really a trade-off. We’ve been crunching some data looking at this. It really depends on how the investor feels about this time decay. For instance, even RIM’s announcement, this past announcement, was made a day before options expiration. What you’ve got is if you enter into this straddle position the day before, the time decay is just huge, as opposed to if you’d gotten the one that’s a month out, the July contract. You’d have much less time decay issues involved there, but you get less price reaction from the option. It’s important that the investor is aware of it. In fact, most basic options traders are aware of it. It’s really going to be an issue of taste as far as a trader is concerned.

Zack: You mentioned there are two components. One is the time component, how far away the expiration date is. The other is how far away the strike price is from today’s price. What has the data shown you on the strike price stuff?

John: We can talk about straddles or strangles. It might be easier to talk [inaudible 17:08]. For instance, if you have a stock that’s trading at $20 and you put on a $20 straddle, what you’ve got is an at-the-money straddle. You’re going to have price movement once the stock actually announces earnings.

A strangle position would be putting on a long put position below the strike price and a long call position above the stock price. What this means is that you’re going to have to have a lot more price movement for the strangle to be profitable.

What we can tell you is that strangles are less often profitable, but when they are profitable they’re much more so. I’ll say the flip side. Straddles, the ones where you go in at the same strike price, are much more likely to be profitable, but when they’re profitable, they’re not as profitable as the strangles.

Zack: Is another way of saying that that it’s a lower risk and lower return?

John: Yeah, sure. You can use that.

Zack: In a probability sense.

John: Sure. Expected return-wise, that’s definitely true.

Zack: I don’t know if this is fodder for this conversation or when the second edition comes out, but how can we increase the probabilities that we actually screen for the most profitable, let’s call them, straddles, because that seems to be your favorite play?

John: Sure. There are three things I would mention. The first is technology is a great play. Because of the nature of technology, the uncertainty that’s at play, subscription-based, there are all kinds of technological issues, when the CEO steps up to the mic and makes an announcement, there’s a real good chance there’s other information that’s compounded in there that’s going to make markets move. The idea of making markets move is a good thing for a straddle. That’s the first thing.

Zack: We want to focus on the technology sector?

John: That’s correct.

Zack: Okay. Next one?

John: The other one that’s kind of related but a little bit different is the idea that any company that’s in the news tends to have something that’s kind of controversial about it or where there’s conflicting information where people are trying to digest different types of, whether it be technologies or whatever it could be. These tend to have also pretty good play.

Zack: How do you quantify things in the news?

John: That’s one of the points. Technology’s nice and easy. You can just look at [inaudible 20:06] count, classifications, etc. This idea of “in the news” is really more ad hoc.

Zack: All types of research has been done to find different measures of that, of newsworthiness, right?

John: There have been. When I mention it right now, we have not performed statistical analysis on this idea of “in the news more.” There have been other studies in other contexts that have definitely looked at this idea of “in the news more.” It can mean simply looking at the newswires to see how often certain companies are coming up. It can be counting the number of times Dow-Jones News Service picks it up. There are a lot of different ways of getting to it. There are pros and cons to each one of these methods. You can already roll your eyes and go, “Wow, really? All you did was count the number of times it showed up in the news?”

Is that good enough? This is the problem with a social scientist in general. He’s trying to capture something and it’s difficult to do.

Zack: The idea’s simple but the quantification of it is more complicated.

John: Yeah.

Zack: We know that something that people are looking at more is going to have more volatility.

John: Right. That’s really the interesting part for the researcher, to have an idea and bring it into fruition, and how to construct it properly. There have been others that have looked at the number of lines of text in, what is it, CNBC transcripts that take place, because the transcripts are online somewhere.

Zack: Wow.

John: There are a lot of different ways to get to this idea of it’s in the news more. I don’t want to give you the wrong idea. This is simply anecdotal on my part as we’re doing research for our new book. The idea that it seems to me, from a very non-statistical point of view, that the more often that it’s in the news, the more likely there are going to be nice, big price changes.

Zack: You had mentioned there’s a third leg, I guess, of how to better your probabilities of finding a winning straddle?

John: By the way, we’re looking at about 50 different corners in the world. I’m mentioning the three right now that come to mind for me. The third corner of the world where you’re going to see the most profitable place, and it almost is in contrast to what I just mentioned to you, but this third corner has been statistically tested. It’s quite robust to several different methods that we use. It’s the idea that the straddles on smaller-sized companies are more profitable. Despite the fact that I have mentioned RIM and Walgreens and other companies, the point is that the truly profitable straddle positions are going to be the ones of fairly obscure names that trade options but tend to be smaller.

Zack: Interesting.

John: This isn’t a contradiction or anything, right? Both of these can be true. It’s just on average.

Zack: I guess the newsworthiness of smaller companies is in contrast to what you said to the second point about how often something shows up in the news. Typically, mid-cap and small cap companies aren’t in the news.

John: Right. This phenomenon for the small companies is really one of this classic idea of they’re more obscure and there isn’t as much information that’s impounded in them. The information leakage that takes place before an earnings announcement happens to be less. It’s what we would actually predict given all the evidence that’s out there among finance guys.

This last finding of the small firms is not that surprising at all. The bad news for the options trader is that these small companies, though they’re more profitable, entering into straddle positions can be much more difficult, much more risky, because you’ve got much . . .

Zack: Less liquidity in the options market?

John: That’s right. You’re fighting . . .

Zack: Which would mean a bigger spread between bid and ask prices?

John: You got it, Zack. Definitely. You’re fighting spreads. You enter into them and you’re already kind of losing. You need a huge announcement to break even and be profitable.

Zack: Is there a baseline spread that say, “Well, let’s just stay away from something like that”?

John: No. We haven’t done that calculation yet.

Zack: Okay. What I think is so interesting about your book also is that just a few years ago, and I’d like to talk about why you think this is the case, that options strategies were relegated to traders or to professionals. I think what your book does a really good job of doing is saying there’s enough information out there and the tools are easy enough to use where individual investors might want to consider these types of things.

John: Definitely so. Obviously, one of the appeals of options is the amount of leverage that you’re getting. One of the other things I think is appealing is they’re just so flexible. We don’t talk about the many different kinds of positions that you can take on. We’ve talked about straddles and strangles and a few other ones. If you have a very specific, nuanced view of what you think a stock is going to do over the next month, two months, one year, there’s a really good chance that you can implement that very specific view through options that you could never do with the underlying stock.

Zack: Should readers of your book expect the second edition, or the next book, to go down that path where you can describe more and more complex options strategies?

John: We’re not going to be looking at too many additional strategies.

Zack: Because they get really complicated for people, especially readers, right?

John: Yeah.

Zack: Without mathematical backgrounds.

John: You have to pull out a pad and pencil and map out what it is that these more complicated strategies are doing. I wouldn’t go out of my way to learn them. What you’ll notice about our book is that we’re really not into being complicated for complicated’s sake. We’re much more into let’s boil down to the essence of what’s going on here. We really do try to keep it at a level where if you wanted to get more complicated you could, but oftentimes there’s no need to. That’s certainly what we’re doing in this book.

The second book, at this point, is morphing as we’re writing it. We’re going to spend a lot more time crunching data to give very actionable corners of the world where you should put on these kinds of positions.

Zack: Very interesting. I’m looking forward to reading the next one. I’m sorry. I want to ask you one more question. I know your voice is fading. As I mentioned before, I think the tools and the information on learning about options have made this, even the emergence of online options brokers, really easy nowadays. Where do you go or where do you suggest people go to find out more information about learning about options or screening for certain options? Are there certain sources that you find yourself coming back to that you either could recommend or just highlight for us?

John: No, I don’t. I suggest you go to your local bookstore and you’ll find that if you ask the guy, “Do you have a good options books,” there are just so many out there.

Zack: What about online screeners? Are there just tools that you’re finding? Is a Yahoo! Finance sufficient enough to screen for the types of straddles that you’re describing.

John: Yeah. Yahoo! Finance, Google Finance, they do have options prices, and you can build out yourself how much a certain straddle would cost. That’s certainly one way to do it. You can go to any one of the options providers, whether that’s e-Trade or TD Ameritrade, and they all have real-time options prices as well as an archive of prices. Those are definitely places to go. I’m not going to pretend to tell you this is the best place to go. Much of what we’re coming from, as far as the books and the resources, is from a theory end. We’re just helping trying to apply it for the average investor.

Zack: Okay. Great. Obviously, we had an announcement recently, Schwab buying OptionsXpress. This, to me, I think, brings options trading even closer to your average investor. What do you see in the future of options trading? More and more people like yourself, academics, who are providing this type of analysis to act upon?

John: Definitely so. From an academic point of view, it’s definitely become a bigger deal because archival data, meaning just historical data that goes back 10 years, is fairly new for academics when it comes to these options prices. It’s just terabytes of data. You’ve got every single stock with an option, every single expiration date, and the chain of all the different strike prices. It’s insane how much information’s out there. It’s just a matter of the academics sitting down, swimming through it, and trying to figure out what are the most important questions to be answered. It’s definitely becoming bigger from the academics’ point of view. It’s certainly becoming bigger from the investors’ point of view because you can basically go to any online trading platform and they will offer options trading too.

Zack: Last question, and I’ll let you go rest your voice. Just curious, do you trade options yourself?

John: Sure. We definitely do.

Zack: Okay. Great. That’s also, I think, a new phenomenon, no? It’s not ivory tower analysis. You’re also actually putting your theories to work with some money.

John: Oh, without a doubt. I think if you read, I forget which chapter it is, but we have a chapter in there about some of the practicalities of putting on these trades. What you’ll notice is that most all of that is not theory driven, but it’s very practical information about when to enter into trade, etc. That just comes from us messing around, us experimenting on our own with trades.

Zack: John, this was really great. I really appreciate the conversation.

John: Not a problem, Zack. Glad to be here. Thanks for interviewing.

Zack: My pleasure. That wraps up this episode of Tradestreaming Radio. Thanks for joining us on this episode with John Shon, the co- author of “Trading on Corporate Earnings News: Profiting from Targeted Short-Term Options Positions.” Check it out. Check us out in the future and let us know what you think.

About John Shon

John is a professor of accounting at Fordham University.  He received his PhD in accounting from the University of Chicago Booth School of Business.  He’s not only an options ninja but he’s also a black belt in Tae Kwon Do.

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Tradestreaming is a community of investors learning directly from experts. I’m Zack Miller, investor, entrepreneur, and founder of Tradestreaming.com and I literally wrote the book on how to invest in the age of Facebook and Twitter. Tradestreaming is the resource I’ve created to help me become a better investor.  I believe it will help you … Continue Reading