I just polished off a trading lab all about earnings reports and how to trade them. We explored the dynamics surrounding these quarterly rituals and the potential strategies you can use around them. My thoughts were inspired in part by my recent appearance on the Trading Justice podcast where we discussed all things earnings and explored how to trade Netflix’s announcement.

Rather than waste digital pixels, I’m keeping today’s post to the point. Consider this a simple breakdown of what happens around earnings and how you might trade it. One line at a time.

One: Earnings season is January, April, July, and October.

Two: These quarterly reports are binary events, a coin flip boasting a 50-50 chance of a bullish or bearish outcome.

Three: Stock volatility increases after earnings, usually in the form of a large gap.

Four: Options get expensive in anticipation of the event, the so-called implied volatility build.

Five: Options get cheaper afterward experiencing an implied volatility crush.

Six: With the event in the rearview mirror, there simply isn’t justification for premiums to remain pumped.

Seven: The market is efficient and prices in how much the stock is expected to move on earnings (aka the Market Maker Move or MMM). Sadly this requires more than one sentence to explain. I’ll use Intel, which reported earnings tonight, as my example. The MMM was $2.93 which translates into a 4.6% move. That $2.93 represents one standard deviation (aka one sigma) move, thus carrying a 68.2% probability. If option premiums are perfectly priced, then Intel should move within the expected range (+/- $2.93 in this case) approximately 68.2% of the time.

Eight: You have three ways to trade earnings:

Nine: Guess the direction of the gap and build a directional strategy to play. I prefer OTM bull calls or OTM bear puts for low-cost speculative trades. If you’re trying to build a higher probability of profit, then OTM credit spreads are the way to go.

Ten: Go long volatility via strategies like long straddles and strangles, inverted flies and debicons. You’re betting options are too cheap or that the stock will move more than the expected move. Per the earlier odds, you’ll probably only win about 1/3rd of the time.

Eleven: Go short volatility via strategies like short strangles and iron condors. You’re betting options are too expensive or that the stock will move less than the expected move. You should win some 2/3rds of the time.

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