Earnings season for the third quarter of 2015 kicked off with the Alcoa (AA) release after the market close on Thursday, October 7.

In anticipation of this important trading period, we are highlighting a recent episode of Market Measures that focused on earnings and theta.

Options trading and corporate news events are linked at the hip because an unexpected change in a company's underlying business potential (i.e. sales or expenses) can likewise affect the price of the stock. Abrupt and extreme changes in the price of a stock obviously have a similar effect on a stock's options.

For these reasons, earnings season can translate to opportunity for options traders with the experience necessary to recognize and deploy high probability trades.

One of the hedge funds that I worked for in the past was especially skilled at the earnings trade. The firm built several sophisticated trading tools that helped identify earnings trades and allowed for auto execution.

However, even without an extensive earnings tool belt, traders can get a leg up by considering several important factors to keep in mind when evaluating earnings-oriented positions.

On the “earnings and theta” episode of Market Measures, Tom Sosnoff and Tony Battista discuss tastytrade research that suggests short premium trades that fall during an earnings cycle may face some additional challenges versus non-earnings expirations.

Essentially, the tastytrade research revealed that option prices that include an earnings release can be held up artificially due to the upcoming binary event. Consequently, realized option decay can be less than theoretical decay forecasted by theta.

In executing this research the Market Measures team analyzed AMZN and IBM for the 30 days prior to their most recent earnings. The parameters of the study were based on one standard deviation strangles (distance from strike) in both AMZN and IBM and included two expiration cycles - one finishing before earnings and one finishing after earnings.

In the case of AMZN, the month before earnings was April and the month that included earnings was May. The results, as shown below, illustrate that the April strangle in IBM decayed as expected, while the May strangle did not. It's important to note that the Y axis on the right side of the chart shows maximum profit.

Notice in the above graphic how the solid red line (April strangle) reached its expected profit potential, whereas the dotted red line (May strangle) did not.

We see almost an identical result in the IBM chart, which was researched using a July strangle (before earnings) and an August strangle (after earnings). The IBM chart depicted below similarly illustrates that the strangle expiring before earnings decays at a rate close to maximum profit (solid red line), while the strangle expiring after earnings again barely decays (dotted red line).

These examples stress the importance in knowing a company's specific earnings date when filtering for the best short premium trades. If the option cycle we are looking to trade expires after a firm's earnings, we may experience less theta decay than anticipated (even if the underlying does not move significantly on the day of earnings).

We encourage you to watch the full episode of Market Measures focusing on earnings and theta at your convenience.

Additionally, we welcome you to utilize the Learn page or the search engine on the tastytrade website to learn more about either of these important concepts.

Please don't hesitate to contact us at support@tastytrade with any questions or feedback.

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.