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One of our readers recently asked me about placing a spread ahead of
earnings report. The company is due to release results Thursday and Sam wants to initiate a bullish trade ahead of the numbers. His first question is, "if VFC is currently at $141.02, would you suggest buying an ATM 140/145 call spread or the OTM 145/150 spread?" Next, he wants to know, "When buying a spread to play earnings is it better buying it a few weeks or days before, or the same or day before earnings?" While there are no hard and fast rules to answer those types of questions, there are a few factors to consider when searching for the best call spread ahead of news.
He is bullish on VFC ahead of the results and therefore he is looking to buy the call spread. The strategy is created by buying one call option, and also selling a call with a higher strike price. The trade is sometimes called a vertical spread or bull call spread. Basically, the investor is taking a bullish position in a call option and selling a higher strike price call to hedge some of the risk from time decay and changes in implied volatility. Selling the higher strike call also limits the potential profits. The max potential profit from a bull call spread is always the difference between the two strike prices minus the debit paid to enter the position. The risk is the debit, plus transaction costs.
Finding the best call spread for a specific stock is a multi-step process that considers the underlying stock's past price action and also the investor's tolerance for risk. If you buy a spread with strike prices that are $5 apart, the maximum potential gain is $5 minus the debit. For example, if you buy a 140 - 145 call spread for $2, the most you can make is $3 (or 145 - 140 - 2). Your maximum potential risk is the debit paid. So, if you pay $2 for a $5 spread, you are risking $2 for the potential to make $3.
The higher the strike prices of the options, the less the debit and the higher the risk-reward. At the same time, the higher the risk-reward of the trade, the lower the probability of success. Let's look at some numbers in VFC. With the stock near $141.65 midday Monday, a February 140 - 145 call spread can be bought for $2.45. The potential profit (excluding transaction costs) is $2.55 if shares close above $145 (+2.4%) with a breakeven at $142.45 (debit plus lower strike), or just 0.6% above current levels. The February 145 - 150 call spread can be bought for $1.25, with a potential profit of $3.75 if shares move to $150 (+5.9%) and an upside breakeven at $146.25 (+3.2%). In the first spread, we're risking $2.45 to make $2.55, a ratio of one-to-one. In the second, the risk-reward is one to three. However, the breakeven is much higher, and therefore the probability of success lower, in the second spread. Simply put, the higher the strikes, the greater the risk-reward.
Another factor to consider is the stock. VFC has seen average daily moves of 6% after earnings were reported over the past four quarters, which is about an $8.50 move. So, if the strategist is looking for a post-earnings pop in the stock, the 145 - 150 call spread makes more sense. If their hypothesis is correct, the reaction could send shares well beyond the 145 strike and towards 150. The 145 - 150 call spread offers a lot more bang for the buck.
Sam also asks, when he should initiate the trade - today or the day earnings are going to be announced? If the idea is to play the profit report, then it is better to wait for the earnings day rather than run the risk of other headlines, broker downgrades, a downturn in the market or other events to send the stock lower and hurt the position before the report. At the same time, however, my experience with trying to predict earnings news has been similar to trying to call heads or tails in coin toss. It's almost a binary event because post-earnings reactions are very difficult to predict. But if someone put a gun to my head and said what spread would you choose: it would be the February 140 - 145 call spread on the Thursday before the earnings are reported.
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At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.