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The much-anticipated financial report of $Nvidia (NVDA)$ will be released after the market closes today, and the market has already been undercurrent.
Today, I will take advantage of a hot topic and write a practical article to talk about how to participate in financial report opportunities through options.
Event-driven opportunities
Earnings report trading is a typical event-driving opportunity .
The release of financial reports is a Known Unknowns event, meaning that the time of occurrence is certain, but the outcome and magnitude of the impact are unknown.
Changes in expectations in financial reports
As we all know, stock prices trade on the market's expectations of the company.
Financial reporting is a process of verifying and reshaping expectations.
The current stock price reflects the average expectations of market traders for the company.
The disclosure of various data in the financial report is a process of verifying the facts against market expectations. Therefore, after the financial report is disclosed, market expectations will converge quickly, which is reflected in the fluctuation of stock prices. If the financial report data is better than market expectations, the stock price will rise; if the financial report data is lower than market expectations, it will be reflected in the stock price falling.
In addition, after disclosing the financial report data of the previous quarter, the company will generally provide guidance on the operating conditions of the next quarter. This will reshape a new expectation after the convergence of expectations, guide market expectations in this direction, and the stock price will change accordingly.
What are the market expectations?
Market expectations are not completely equivalent to analysts' consensus expectations. We often see that even though the financial report exceeds analysts' expectations, the stock price still falls, which shows that there is a difference between the market's true expectations and analysts' expectations. Market expectations are often vague and can only be truly revealed after the financial report is released.
Certainty and uncertainty in financial reporting
Since the market’s true expectations are uncertain, and the rise and fall of stock prices are also difficult to predict for our analysis, what else is certain?
Certainty of time
The financial report is a known unknown. Since the time of the financial report release is certain, the event of stock price changes after the financial report is also certain, that is, before and after the market opens after the financial report is released, and for a period of time after the market opens. The process of expectation convergence and reconstruction will take place during this period, which means that stock prices tend to fluctuate significantly.
The Certainty of Volatility
Because financial reporting is a process of convergence and reconstruction of expectations, stock price fluctuations are often inevitable.
Therefore, before the financial report is released, the market's expectations for the underlying volatility will rise sharply, which is reflected in a sharp increase in the corresponding option's implied volatility (IV).
We know that expected volatility and actual volatility will tend to be consistent in most cases. They will deviate briefly under the influence of special events, but will eventually tend to be consistent.
在财报事件当中，财报公布后，在短暂的交易时间段里，实际波动率在大多数情况下会显著上升（除非市场预期与财报结果较为一致），体现为股价的大幅波动；
In most cases, the expected volatility will decrease during the same time period, which is reflected in the decrease of IV of the corresponding option (often called IV crash), because the market expects that the actual yield will gradually decline after the impact of the event shock subsides and the stock price stabilizes.
How to build a trading portfolio
Once you understand the basic characteristics of earnings events, you can build a trading portfolio to profit from them.
Here we take NVIDIA as an example to analyze several forms of participation.
Directional trading
If you are particularly optimistic that the stock price will fluctuate in a certain direction after the financial report, you can make directional trades.
For example, if you are optimistic that Nvidia’s financial report will exceed expectations, you can make a bullish combination; if you are optimistic that it will fall short of expectations, you can make a bearish combination.
Among them, the simplest is to buy or sell short the underlying stock. The benefits and risks are linear. If you bet on the right direction, you will make money, and if you bet on the wrong direction, you will lose money. However, due to the uncertainty of expectations, the rise and fall are very random, so this model has become a bet on the size.
The second method is to use options, but the risk-return of options is nonlinear.
Buying call/put : Most people use this method to bet on financial reports. Due to the high IV premium before the financial report, the price of options will be relatively high. Therefore, in most cases, even if you bet on the right direction, if the volatility is not enough, the value will be eaten up by the IV crash. The advantage of this method is that the upper limit of loss is the premium returning to zero, and once the bet is on the right direction and the volatility exceeds expectations, the profit will be very high. This is a method with low winning rate and high odds.
Selling call/put : It is the opposite of the previous form, but in practice, it is generally sold at a certain position outside the price to keep a sufficient safety cushion. The advantage of this mode is that it can not only take advantage of directional gains, but also take advantage of iv crash gains, so even if the direction is sometimes misjudged, it can still gain benefits. However, once it is penetrated by a large reverse fluctuation, it is easy to suffer exponential losses. This is a high-win but low-odds play.
Spread
In fact, Spread is a variation of the above two modes. It can be divided into two categories:
1) Spread
The variants of buying call/put are divided into bull call spread and bear put spread, that is, on the basis of buying options, sell the same number of options of the same type and expiration date with a longer strike, forming a combination of net premium expenditure. The advantage of this is that the cost of buying options is reduced, and it is not so painful to return to zero, but the upper limit of profit is capped;
2) Income Spread
The variants of selling call/put are bear call spread and bull put spread. On the basis of selling option, the same number of options with the same expiration date and a longer strike are purchased to form a combination of premium income. The advantage of this is that it limits the upper limit of loss, but the premium income obtained will be reduced, but it can prevent black swan-like unexpected fluctuations.
Directionless Trading – Volatility Trading
As mentioned earlier, it is difficult to judge the direction of financial report trading, but volatility has strong regularity, so volatility trading is more appropriate.
Taking NVIDIA as an example, the IV of the current expiring options is around 148%. Based on the comparison with its historical volatility, it can be roughly deduced that the market expects the volatility of NVIDIA after this financial report to be around +-10%.
So what should we do specifically around this volatility?
Long Volatility
If we expect Nvidia's volatility to exceed 10% after this earnings report, we can go long on volatility to profit.
1) Buy straddle
The most typical way is to buy a straddle or a strangle, that is, to buy the same number of calls and puts at the same time. No matter which direction the price fluctuates, as long as the fluctuation range exceeds 10%, you can make a profit, otherwise you will lose the premium.
In simple terms, this mode consumes gamma, but it will inevitably face the impact of iv crash (loss of Vega).
Since both sides need to be bought, the cost is basically twice that of buying one side, so the fluctuation range needs to be larger to make a profit. However, once there is an unexpected fluctuation, the profit is very substantial. It is a low-win and high-odds gameplay.
2) Variant: Expenditure Iron Hawk
An iron condor is a combination of buying a straddle or wide straddle and then selling the same number of wide straddles at a further end, forming a net premium expenditure iron condor. It can also be considered a combination of a bull call spread and a bear put spread.
This combination is essentially bullish on volatility, selling in a wide straddle format, which reduces the cost of premiums and, to a certain extent, the volatility required to make a profit, but it also caps the upper limit of returns.
If we are moderately bullish on volatility, for example, we believe the volatility may reach 8%-10%, but it is unlikely to exceed 12%, we can use this combination.
1) Selling straddle
The most common way to short volatility is to sell wide straddle options, such as selling out-of-the-money calls and puts with a range of 10% from the current price to build a combination. When the actual volatility is less than 10%, you can make a profit.
This mode mainly relies on vega (i.e. IV crash profit), but will face the impact of gamma.
Since both sides are sold, the premium on at least one side can be obtained steadily. In most cases, vega's profit can be 100% reaped. When the actual volatility is small, both sides can be reaped.
However, once unexpected fluctuations occur, the loss of this model is also exponential. Therefore, this is a high-win-rate, low-odds play.
2) Variant: Income Iron Hawk
An income-type iron condor is to sell a wide straddle and then buy the same number of wide straddles at a further end, forming an iron condor combination with net premium income. It can also be considered a combination of a bear call spread and a bull put spread.
In essence, it is also bearish on volatility, and the purchase of a wide straddle offsets part of the premium income.
The advantage is that it sets an upper limit on the maximum loss, helping to prevent black swan-like unexpected fluctuations, while also reducing margin requirements to a certain extent.
3. Long and Short Volatility – Ratio Spread
What if we are moderately bullish on volatility, that is, we believe that volatility will be around 6%-10% and unlikely to exceed around 15%, then we can build a ratio spread portfolio.
Taking call as an example, you can buy a 141 call at about 10% out-of-the-money, with a premium expenditure of 2.37; and then sell two 148 calls at about 15% out-of-the-money, with a premium income of 1.13*2=2.26, and a net premium expenditure of 0.11, which is basically break-even.
The advantage of this combination is that it can obtain higher returns in mild fluctuations. If the volatility is moderate, the value of both the call option and the put option can be obtained. In the case of opposite directions or small fluctuations, since the opening cost is almost 0, it is possible to avoid losing money.
The only risk point lies in the unexpected positive fluctuation, that is, if the stock price fluctuates sharply upward, a large loss will be suffered.
This is equivalent to having a risk exposure of a put option.
Compared with unilateral call buying, the advantage of ratio is that it can open a position at 0 cost and can guarantee no loss even if the volatility is not as expected. The disadvantage is that there is an upper limit on the profit, and in the event of unexpected volatility, losses will be incurred.
Compared with naked calls, the advantage of ratio is that it can significantly increase profits under moderate fluctuations, while increasing the volatility of the break-even point, but the premium income will be lost when the volatility is small.
Similarly, we can also construct the put ratio at the same time to form a bilateral ratio spread combination.
Which strategy to choose
The above introduces several options combination methods for participating in earnings event trading. Now let’s go back to Nvidia’s earnings trading and analyze what strategy should be used.
Based on the current IV of $NVIDIA(NVDA)$ at 148% and a comparison with its historical volatility, we can roughly deduce that the market expects NVIDIA's volatility after this earnings report to be around +-10%.
Let’s review the historical fluctuations in previous periods:
The representative financial report starts from the 20230525 period. The previous period did not have the concept of AI, so the fluctuation was small and it is not referenceable.
On May 25, 2023, there was a historic level of volatility. Due to the explosion of the AI track, the financial report exceeded expectations. Under this stimulus, the stock opened +24% higher that day, with the highest intraday volatility increase of +29%, and finally fell back to close with an increase of +24.37%;
20230823, the financial report exceeded analysts' expectations, but the market opened higher and then fell, closing up +0.1%;
On November 21, 2023, the financial report exceeded analysts' expectations, but the market opened flat and closed down -2.46%; the background of these two periods was the phased cooling of AI and semiconductor tracks;
20240221, AI concept ignited enthusiasm again, financial report exceeded expectations, and then opened high and closed up 16.4%;
20240522, the most recent period, the financial report still exceeded expectations, opening and closing up 9.32%.
Looking back at the performance of previous financial reports, since May 2023, Nvidia has exceeded expectations for five consecutive financial reports, but the market reactions have varied, indicating that analysts' expectations are not a reliable indicator of the market's true expectations.
Let’s take a look at Nvidia’s current stock price.
First, the stock price is still near its historical high, about 9% away from the new high, and has increased by 159.08% this year.
Secondly, the actual volatility has risen sharply, showing a trend of sharp rise and fall recently. The historical volatility counted in options has reached 63.90% (the volatility under normal circumstances is generally between 20% and 30%).
Then let’s consider these questions:
As stock prices continue to rise and exceed expectations for several consecutive periods, could it be that market expectations have actually reached a very high level? What is the possibility that this period will still exceed expectations?
How will the market react if this period's financial report is not as good as expected?
After everyone has considered these questions, I believe everyone will have their own answers, and then choose the appropriate strategy to participate based on their own judgment.
Carolina Dybeck Happe is a true visionary on global financial transformation and value creation. As the CFO of General Electric, she led their recent transformation in partnership with CEO Larry Culp that will form three independent, investment grade public companies, to be completed with the final GE Vernova spin-off in early 2024. Carolina joined GE as Senior Vice President and Chief Financial Officer in March 2020, a critical time in the company’s history, and played a crucial role in improving the company’s financial and operating performance and building the strategy and execution of GE’s spin-off plan through her leadership of GE's global financial organization and the transformation program.
Prior to joining GE, Carolina served as CFO at Maersk, where she led a value creation effort through substantial deleveraging and reshaping the company’s portfolio to deliver more profitable growth. Before that she was CFO at ASSA ABLOY, where she helped transform the company into a global, digitally enabled innovation leader providing access solutions.
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