Earnings season is perhaps one of the most alluring times for investors to get involved in the options market, and the most dangerous if you're not careful.
In these times of dramatic moves after earnings announcements, professional traders often use options to speculate ahead of quarterly reports. The game can be played by individual investors.
The most intrepid will simply buy a call if they think earnings will move the stock higher and a put if they think a quarterly report will relegate a stock to the scrap heap.
There are other strategies in which investors can use options during earnings season, according to John Power, a former
Chicago Board Options Exchange
investor-education maven and now the head of marketing at
BOTTA Capital Management
, a market-making and trading firm.
One way to use options around earnings is to buy or sell a straddle. Buying a straddle works like this: You buy an at-the-money call and an at-the-money put with the same strike price and the same expiration.
An investor would buy a straddle on the expectation that the underlying stock is going to make a huge move; the direction of the stock doesn't matter because you're buying a put and call.
The investor profits if the move in the underlying stock is greater than the amount of money the investor laid out to buy the options. The most an investor can lose in a long straddle is the amount paid to buy the options.
One option is likely to expire worthless but the appreciation of the other option will make up for that loss.
In what's called a short straddle, you sell an at-the-money call and an at-the-money put with identical strike prices and expiration. You would use this strategy if you expect that the underlying stock is
going to move much.
The maximum profit you can earn in a short straddle is the amount of premium you take in for selling, or writing, the options contracts. The risk is unlimited if the underlying stock moves dramatically in either direction because the writer of the options contracts has to live up to the terms of the call or put option contract.
Power points out that often, investors buy options -- either puts or calls depending on their opinion -- ahead of earnings.
Sure, this is more complicated than simply buying either a put or a call, but there are two risks associated with going long options ahead of earnings, BOTTA's Power notes. The investor could be wrong on the direction of the stock, or worse, correct about the direction, but the stock price move might not be dramatic enough to make the trade worthwhile.
One of the key factors in successfully trading options during earnings season is realizing that options prices get inflated ahead of quarterly reports. That happens because earnings often prompt dramatic moves in the underlying stock, making the leverage options provide essential. Market makers see this demand, and the uncertainty associated with a potential big move, and raise the prices of those options. (Technically, it's called rising implied volatility. For most investors, it's enough to know you're paying more.)
Once those earnings are reported, however, that uncertainty that caused the price to rise is gone and the implied volatility portion of the option's price starts to evaporate. So even if the stock moves up, the option's price may be under pressure.
Another strategy Power points to during earnings is what's known as a
bull call spread
Relax, it only sounds tough. Here's an example from Larry McMillan's tome,
Options As a Strategic Investment
If a stock is trading at $32, an investor would buy a call with a $30 strike price (paying $3 for the call) and sell a call option with a $35 strike price (and collecting $1 for it). In this strategy, both the risk and upside are limited.
The maximum profit is seen if the underlying stock is trading above $35 at expiration, the book notes, while the most you can lose is if the stock is trading below $30 at expiration.
If the stock is at $35, the call option with the $30 strike price is worth at least $5 (depending on the time remaining until the option's expiration and the volatility). At the same point, the $35 option likely would go unexercised because buyers wouldn't be able to exercise at break-even because the stock price hadn't climbed to exceed the price of the stock plus the price they paid for the option itself.
Also, investors can use another strategy called a
. Power cautions, however, that the underlying stock will have to make a big move for such a trade to be worthwhile.
Here's an example of how a backspread would work, also taken from McMillan's book. If a stock is trading at $43, to put on the backspread, you'd buy two 45 calls for a total of $2 in premium and sell one 40 call for $4, for a credit of $2. The book points out that if the stock rallies big-time, the profit is unlimited because you own more call options than calls you sold.
You'd make a profit from the trade even if the options expired worthless because you'd still have the $2 credit, McMillan's book points out. The most an investor can lose is a total of $300. The book notes that if the stock is at $45 at expiration, the calls will expire worthless, for a loss of $200 and the 40 call that the investor sold will have to be bought back for $5 ($500), 100 bucks more than what was paid for them.
If the stock takes off, "your profit from the two you're long can be substantially more than the loss from the one you're short," Power says.
So there you have it. Earnings season doesn't need to be an all-or-nothing time for investors who tread carefully. These options strategies can get you through this and any earnings season.
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